Isaac Newton, Daniel Defoe and the Dynamics of Financial Bubbles SCIENCE SOURCE SCIENCE traveler1116

By Andrew Odlyzko historical context. The public was less edu- groups having wildly divergent percep- cated than today, and there was far less of tions of what reported events mean. This A famous anecdote tells of Sir Isaac both finance theory and of general infor- is often blamed on the overabundance of Newton realizing large gains in the early mation about business and the economy. information. However, similar phenom- stages of the South Sea Bubble, but then On the eve of the South Sea Bubble, ena can be found three centuries ago, in losing all that and more by buying back in Britain was beginning to enjoy the fruits an era of information scarcity. This can be at the top. On the other hand, the fact that of the peace that came after the long and observed in politics, as well as in reactions the author of Robinson Crusoe was also debilitating War of the Spanish Succes- to the South Sea Bubble. associated with that episode of extreme sion. It was widely ranked with Holland as Like today, information systems were investor exuberance is little known. And a world leader in technological and com- being revolutionized. The press was that is a pity, since Daniel Defoe’s words, mercial development. International trade undergoing rapid development, following as well as Newton’s actions, are very illu- was booming, but not without contro- the removal of some of the shackles of gov- minating about an important aspect of versy. Weavers were rioting against the ernment censorship two decades earlier. bubbles that deserves much more atten- imports of inexpensive Indian textiles, London was full of a variety of publica- tion. This is the social network element, and one of Defoe’s many jobs was writ- tions, as entrepreneurial publishers strove involving information dissemination ing a newspaper set up by the weavers to to find profitable niches, often by catering among investors. What did they know, push their case for protection. Politics to political parties, or the government, how did they know it, how accurate was was extremely partisan, with widespread that paid them secret subsidies. Yet the what they thought they knew and how suspicions and accusations of treason. commercial newsletter sector, distributing did they interact with each other? Some were well-founded, as there had large numbers of hand-duplicated cop- The South Sea Bubble of 1720 had all been a major Jacobite invasion in 1715, and ies, continued to thrive and served as an the essential ingredients that make invest- a smaller uprising in 1719, both aiming to essential feed for the press, especially for ing today challenging: political turmoil, restore the Stuart dynasty. the provincial press that was in its infancy, rapid globalization, business innovation, Today the traditional press is in decline, with just a handful of papers. new communication technologies with an and social networks and related upstarts abundance of “fake news” and novel finan- are beginning to dominate. We are forced cial products that befuddled investors. to grapple with the issues of “echo cham- Those securities might seem simple to us, bers” and “filter bubbles,” which produce Portraits of Sir Isaac Newton (left) and Daniel Defoe but this has to be considered in proper the “post-truth” phenomenon of different (right), both investors in the South Sea Company.

18 FINANCIAL HISTORY | Winter 2018 | www.MoAF.org We can monitor the torrents of infor- Soth Sea Stock Prices in 120 mation that flow through traditional news 000 media, as well as some modern systems , such as Facebook and Twitter. But we 1 have limited ability to understand those flows, and we have only a vague sense of what goes over some other media,

such as encrypted chat sessions. We face 800 similar hurdles when studying the South Sea Bubble. We do have large collections of printed material from that period, as well as a few personal letters and the like.

However, all available accounts argue that 600 a key role in the transmission and collec- tive processing of information at that time was played by coffee houses. That is where P people gathered to read the papers, gossip

400 Newton buys for Hall and analyze what they had heard. We have very little knowledge about how this oper- Newton buys ated. Thus, just like today, we have to make do with fragmentary information on how Newton sells investment decisions were made. 200 Thomas Guy sells Having to deal with shadowy fragments of reality does not mean we cannot obtain enlightening insights from comparisons of the events of three centuries ago with Feb Mar Apr May Jun Jul Aug Sep Oct today. One feature that appears to char- 0 acterize bubbles is greatly increased gull- 246810 ibility among investors, as well as policy makers. As I write this article in early 2018, we observe initial coin offerings (ICOs), in which investors rush to throw their money after the crash through diplomatic pres - been studied intensively. What we can do at promoters who rarely offer business sure on Austria. But there is far more that is to exploit those works from a financial plans, much less plausible ones. The simi- can be learned, in particular about the history point of view. larity to the South Sea Bubble story of a activities of individual investors, the infor- Here we briefly discuss some of the his- company “for carrying on an undertaking mation that was available, how it was used torical nuggets that have been uncovered of great advantage, but nobody to know and, in most cases, how it was not used. recently, primarily about Daniel Defoe, what it is” is striking. (It has to be said that The newspapers and pamphlets from Isaac Newton and Thomas Guy. Defoe has while the 1720 story appears embellished that period have already been mined by not attracted much attention in financial from its apocryphal origins, it does not previous investigators, but not completely. history. But his economics, that in Rob- exaggerate too greatly the promotional And there are sources that have barely inson Crusoe as well as his other profuse atmosphere of that time.) What this sug- been scratched. Those include complete writings, has already been studied. He was gests is that we might perhaps be able to records of trading in many of the main an extraordinarily prolific and versatile develop a measure of public gullibility that securities on the London market. They also writer. His works are especially valuable might serve as a warning sign of bubbles, include a substantial body of modern pub- because he had a very modern mindset, in just as high levels of debt do. lications about the history of the British terms of how he viewed and described the While there is already extensive litera- press and the history of English literature. world. This led historian G.M. Trevelyan to ture on the South Sea Bubble, much more Many of the famous literary figures entitle the chapter on the early 18th century can be learned about that episode. The from that period, such as Daniel Defoe, in one of his books as “Defoe’s England,” in standard accounts tell us about the brib- Jonathan Swift, Richard Steele and Alex- recognition of this writer’s value in creating ery and fraud committed by the South Sea ander Pope, were involved in the South Sea and describing that era. Unlike most of his Company, its manipulation of the market, Bubble, either as investors or as propagan- literary contemporaries, Defoe was keenly the price record and many other colorful dists. Since they were literary figures, they interested in commerce and finance, based aspects of this multisided affair. wrote extensively, unlike people in finance, on personal experience in those areas. In particular, they include the British who typically left few traces. Further, since Defoe appears to have played a role, government’s successful efforts to suppress they are now famous, their writings have possibly a very important one, in the some of the extremely embarrassing facts

www.MoAF.org | Winter 2018 | FINANCIAL HISTORY 19 creation of the South Sea Company, also strong attacks on the South Sea proj- which was at the center of the bubble. ect in other papers that are sometimes Contrary to popular reputation, this ven- claimed to be by Defoe. The attributions ture at its start in 1711 was a very innova- there are less certain, but not impos- tive financial experiment that turned out sible, as he was known to employ his to be extremely successful. Essentially, it talents simultaneously on several sides of converted a large volume of British gov- an issue. With more research, we might ernment short-term debt into long-term obtain more clarity on the positions that bonds. It continued prospering through Defoe took on the South Sea project. the 1710s, and it was only the Bubble Half a dozen years after the collapse of of 1720, portrayed in the price chart, the bubble, in his book The Complete Eng- that gave it the notorious reputation it lish Tradesman, he placed the blame for the still carries. During the earlier halcyon debacle on investors in general: “Avarice days of the 1710s, the South Sea Com- is the ruin of many people besides trades- pany attracted many solid investors, men; and I might give the late South-sea such as Newton and Guy. In addition, calamity for an example, in which the investors in the South Sea Company longest heads were most over-reached, who did nothing during the bubble not so much by the wit or cunning of emerged from that episode with signif- those they had to deal with, as by the secret icant profits, as there was a substantial promptings of their own avarice.” Ponzi element to this scheme. This 1720 letter documenting one of One of those “longest heads” was At the end of 1719, Defoe wrote The Isaac Newton’s South Sea Company Newton, who, in addition to his scien- Chimera, a strong critique of John Law’s investments was on view in the Museum’s tific accomplishments that were widely Mississippi Scheme. This was the first 2008 exhibit, “Art of the Exchange.” celebrated, was the Master of the Royal large-scale financial bubble in history. (The Mint and a respected and effective civil Dutch Tulip Bulb Mania of the 1630s was servant. Unlike Defoe, Newton has left more of a tempest in a teapot.) It was then very little written record of his views reaching its height in France, and Defoe on investments. However, he was a very pointed out its many defects and warned of and run by a truly innovative economic wealthy person, and the records of his its instability. He contrasted Law’s vision- thinker, John Law). But that was not how financial moves provide a more eloquent ary experiment with the solidity of British Defoe presented the situation. and trustworthy testimony to what he finance. However, the apparent flourish- The Commentatorfolded just as the really thought, as he was disposing of his ing of Law’s venture, and its success in bubble was collapsing in September 1720. money and that of an estate of a friend. relieving France of the burden of its giant A month later, Defoe was put in charge In the past, the anecdote of his cashing national debt, inspired Britain to attempt of The Director.This paper was devoted out early and then getting back in at the a similar feat via the South Sea Company. exclusively to the South Sea affair, and it top of the South Sea Bubble was supported From the beginning of 1720, Defoe ran may have been set up by those directors of by just half a dozen solidly documented fig- The Commentator, a newspaper that was the company who were not in the inner ures and a couple of stories written down a likely subsidized by the government. He clique, to deflect blame from themselves. generation or two after his death. Recently, continued to attack Law’s French scheme Defoe mounted a valiant but doomed substantial additional information has been and was vociferous in his condemnation effort to support the market price of South gathered, based primarily on the records of of the various visionary London schemes, Sea securities, and in the last issue of this Newton’s trading in securities other than such as a company “For extracting Sil- paper presented a laughable account of those of the South Sea Company, and also ver from Lead.” He called them various just how much the taxpayers had saved as on the detailed records of investments of names, such as a “lunacy” caused by the a result of the bubble. the estate of Thomas Hall, where Newton “bubble infection.” Exactly what Defoe thought privately was one of the executors. However, he was supportive, with only is impossible to say, as what he wrote in The picture we obtain of Newton’s minor cautions, of the South Sea project, the cited papers was clearly in line with investments is still incomplete, and likely which had most of the financially dubious his sponsors’ desires. Furthermore, it is to remain so. But it is rather convincing features of Law’s venture. Defoe claimed it extremely difficult to determine which and suggests that at the beginning of 1720, compared to the Mississippi Scheme like of the works from that period may be Newton had around 40% of his consider- “a real Beauty and a painted Whore.” In attributed to Defoe. Almost everything he able wealth (comparable, based on average retrospect, it is easy to argue that the Mis- wrote was published anonymously, includ- earnings, to around $30 million today) sissippi Scheme had far greater chances of ing Robinson Crusoe. in South Sea stock, which can be thought success than the South Sea venture, as it The citations in this article are taken of as a book-entry equivalent of shares. was launched in a richer country and had from works that are overwhelmingly This stake had been acquired over some a larger scope (as well as being inspired accepted as by Defoe. However, there are years, mostly at considerably lower prices.

20 FINANCIAL HISTORY | Winter 2018 | www.MoAF.org But then, as the bubble was inflating, in Still, Guy did make big profits, as he had Newton were reacting to those skeptical April and May 1720, he sold most of that, bought in over the years at less than a arguments. On the other hand, prices did at prices that were three to four times quarter of his sale price, and his short sale not vary much at the time those publica- his cost. This liquidation appears to have losses were moderate. His reputation as a tions appeared, so if Guy and Newton were stretched roughly over the period shown sagacious financier who successfully rode motivated by them, they were in a minority. in the price chart. However, a few weeks the South Sea Bubble is well deserved. These stories illustrate the various after the last of those sales, in mid-June We do obtain some hints of what may courses of action taken by investors in 1720, he appears to have jumped back into have caused Newton’s switch from a skep- the South Sea Bubble. There is far more the market, at prices about double those tic to an ardent believer in the bubble. Just that can be done along similar lines, and at which he had sold. He then continued as he was completing the sales of his own the hope is that additional investigations making further investments for himself holdings, he executed what were, in effect, will teach us more about the information until the end of August, just before the purchases for the Hall estate, and those flows during the South Sea Bubble. Ideally collapse of the bubble. are marked in the estate records as having this will provide insights into the general Newton’s misadventures in the South Sea been carried out at the request of Fran- dynamics of bubbles. Bubble are of interest not just because of his cis Hall, the principal beneficiary of that fame. He represented an apparently very estate. This was followed by some more Andrew Odlyzko has had a long career small fraction of investors, namely those purchases for that estate, again after calls in research and research management at who were initially skeptical of the bubble from Francis Hall, and then a big move of Bell Labs, AT&T Labs and, most recently, to the extent of selling out, yet eventually Newton’s own funds into South Sea stock. at the University of Minnesota, where yielded to the groupthink that moved the There had to be vigorous debates among he built an interdisciplinary research vast majority of investible funds in Britain all the executors and Hall about the pros- center and is now a professor in the into the hands of the South Sea Company. pects of the South Sea venture, with Hall School of Mathematics. He has written There were numerous other skeptics who likely the most fervent enthusiast. Those over 150 technical papers and is cur- held to their views, and some of them real- debates, together with the rapidly-rising rently concentrating on financial history ized large profits. Probably the most famous market price, apparently led Newton to and technology bubbles. All of his recent example is Thomas Guy, whose name is change his mind. papers are available at http://www.dtc immortalized in the name of the hospital It should be noted that Newton did .umn.edu/~odlyzko/. he founded largely with the profits from the become a truly ardent believer in the bub- bubble. As with Newton, the outline of the ble, more ardent that other people in his Sources widely-accepted story is correct, but recent circle, even though he started out as a skep- Anderson, Adam. An Historical and Chronologi- studies of Guy’s investment books show tic and was slow to change his views. The cal Deduction of the Origin of Commerce, from some previously unknown twists to it. Hall estate made some purchases of South the Earliest Accounts to the Present Time. Guy started liquidating his South Sea Sea stock as late as the middle of Septem- Vol. 2, A. Millar, 1764. See https://books stock holdings, about five times larger ber, when prices were in a free-fall and .google.com/books?id=JANYAAAAcAAJ. than Newton’s, at about the same time about half their peak level. However, this as Newton. Guy completed his sales at estate did keep a substantial fraction of its Carswell, John. The South Sea Bubble.2nd edi- almost the same time that Newton started assets in a more stable investment, that of tion. Alan Sutton. 1993. buying again, as is shown in the price the Bank of England. On the other hand, Chancellor, Edward. Devil Take the Hindmost: chart. It turns out that later he did make Newton appears to have put all of his A History of Financial Speculation. Farrar, some purchases, but this appears to have assets into South Sea stock. Straus, and Giroux. 1999. come from motives different than New- The near coincidence of the dates when Dale, Richard. The First Crash: Lessons from ton’s. Guy had not only sold out his Guy and Newton starting selling their the South Sea Bubble. Princeton University South Sea holdings, but also sold some call South Sea holdings may be purely acci- Press. 2004. options, and his purchases were meant to dental. There is no evidence that they Neal, Larry. ‘I Am Not Master of Events’: The cover those short sales. The losses he sus- had any direct interactions, although when Speculations of John Law and Lord Lon- tained were substantial, but they were only Newton sold his government securities in donderry in the Mississippi and South Sea a fraction of his gains. mid-June to invest again in South Sea Bubbles. Yale University Press. 2012. Overall, Guy appears to have had the stock, Guy was among the purchasers, correct view of the bubble from the start, likely through a broker. But this coinci- Odlyzko, Andrew M. “Bubbles, Gullibility, and and he never wavered. His market tim- dence may reflect common reactions to the Other Challenges for Economics, Psychol- ing was not perfect, as he sold his South same new information they received. ogy, Sociology, and Information Sciences.” Sea stock at an average price of £420, Prices of South Sea stock had been First Monday. Vol. 15, No. 9. September only about half the peak value it reached mostly stable for almost a month when 2010. See http://www.uic.edu/htbin/cgiwrap/ afterwards. Also, his sales of call options Guy and Newton started selling. However, bin/ojs/index.php/fm/article/view/3142/2603. would have been very profitable, had the several pamphlets appeared just around Odlyzko, Andrew M. “Newton’s Financial expiration date been a month later, as by that time, with very negative evaluations Misadventures in the South Sea Bubble.” that time market prices were cratering. of South Sea prospects. Perhaps Guy and See https://ssrn.com/abstract=3068542.

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