Market Risk
A Picture of the wonderful year 1637 when one Fool hatched another, the Idle Rich lost their Wealth and the Wise lost their Senses.
Sub-title from Dutch caricature by painter Pieter Nolpe, referring to the Dutch tulip frenzy.
The South Sea Bubble (1720)
Capitalism has come to view the stock market, even the New York Stock Exchange, as the prime example of the free market in operation, if not the embodiment of the free market itself. If someone wants to see the free movement of capital or how capitalism is supposed to operate, they need only look at the stock market in its daily operation. There is the notion that capitalism is a fairly recent phenomenon, really only possible in advanced societies. Whether capitalism is considered something totally different from what preceded it or merely an extension of earlier practices, its rise did provide a host of new investment tools, and an exponential increase in the scale of investment possibilities.
In 1711 a group of merchants, headed by Robert Harley, formed the South Sea Trading Company. The British government agreed to convert £9,500,000 of the national debt into South Sea stock. Although the original debt was unsecured by tax revenues, the government agreed to guarantee interest of £600,000, out of specified import duties. While it was primarily a financial corporation, it had received a monopoly on British trading privileges for South America and the Pacific Islands, in expectation that negotiations over an end to the War of the Spanish Succession would provide lucrative trading opportunities. The Peace of Utrecht, signed in 1713 by Philip V, granted fewer concessions to the company than hoped. Despite the limited return from its trading privileges, the government arranged a second stock conversion in 1719, for some £1 million of 1710 lottery orders.
In 1720, a third conversion was carried out. Out of a total British national debt of £51,300,000, an annuities portion, amounting to some £31 million, was to be converted to stock. The government agreed to pay interest on converted stock of 5 percent until 1727 and 4 percent thereafter, suggesting a guaranteed return. Unfortunately, the government also provided an incentive to the company to inflate the value of the stock. Instead of pledging, or securing, the issued stock at par value, £100, the company was allowed to use the market value of the stock as security. The excess value was considered to be 'profit,' allowing the excess shares to be sold. Rumors began to circulate that the Spanish concessions had been far more generous than believed, and that the South Sea trade would prove extremely profitable. The value of the stock increased from £128 in January, to £745 in June, to its peak at over £1,000 in July. Large investors, anticipating a drop in price, began to sell. By mid-September the price had fallen to £520 and, in October, was around £290, then fell to £150. The collapse of the South Sea company stock itself was only one problem. The seeming good fortune of the South Sea investors had spawned a number of fraudulent companies and schemes. While the Bubble Act of 1720 eliminated some of these schemes, by outlawing uncharted companies, many investors had been ruined.
Tulipmania (Tulipomania) (1636 - 1637)
The Dutch Republic had endured its own version of the South Sea Bubble some eighty years before. The Dutch began to take a serious interest in tulips by the 1630's. In 1635 forty bulbs were selling for 100,000 florins. An auction in Alkmaar for a local orphanage, held on February 5, 1637, raised 90,000 guilders, (equivalent to about £6,000,000 in modern terms) selling 99 lots of bulbs. A single bulb of a tulip called 'Admiral Liefkens' sold at the auction for 4,400 guilders. Another bulb, ' Admiral van Enkhuijsen,' went for 5,400 guilders. The auction was perhaps the last major sale of tulips, since dealing in tulip bulbs was suspended in mid-February 1637.
Following the suspension, the tulip craze turned into something of a legal battle between growers and investors over the question of blame and, perhaps more importantly, the level of damages to be assigned, once fault had been determined. The growers fired the first salvo. On February 24, 1637, at a meeting in Amsterdam, they issued a statement that sales made up to the end of the previous planting season (November 1636) were to be treated as binding contracts. Sales made after that date could be cancelled by the buyer, with a payment of ten percent of the price. Few buyers were interested in, (or could afford) even a contract which had been discounted by 90 percent. Buyers in Holland and West Friesland countered with a petition asking for the cancellation of all transactions concluded during the previous winter. In May 1638, an arbitration council set up in Haarlem fixed the liquidation price for contract cancellation at 3.5 percent of the original price, with the seller keeping the bulbs.
A bigger fool will come along...
In trying to explain the seemingly irrational behavior which precipitates panics or financial crises, such as the South Sea Bubble, market analysts have coined the phrase, ' a bigger fool will come along.' (The full phrase is roughly 'I may have been a fool to buy at such an inflated price, but a bigger fool than me will come along to buy at a higher price still.') In 1721 or 1722, it was obvious that South Sea company stock prices had been unrealistically high in 1720, hindsight being what it is. However, it is doubtful that investors worried about losing out on a potential fortune in 1720 would have characterized themselves as fools at the time. Since the price of the stock was not tied to anything tangible, the only evidence of its value was the recent history of increasing prices. Rising prices appeared to be the norm, although investors might be criticized for using a window of only seven or eight months to determine normalcy.
The South Sea Bubble and Tulipmania were instructive, both for what they said about capitalism, and for what they taught about investor psychology and prudent investing. If capitalism was all about the free movement of capital, it provided little guidance and few protections for those deciding to take advantage of that freedom. On the investment side, the basic lesson was that nothing comes for free. Sound investment decisions require careful study and hard work. It is unwise to invest on a 'hot tip' or to make snap decisions about stock based on the actions of the crowd.
Investing failures aside, the South Sea Bubble and Tulipmania said something about the state of the British and Dutch economies. If it said that investors could be foolish, it also said that they had become relatively prosperous, and that the underlying economies were sound. The Dutch economy in the 1630's was beginning to recover from the depression suffered in the 1620's. While tulips may have been in the limelight, Dutch investment, in reality, was both diversified and successful. Dutch East India Company (VOC) shares on the Amsterdam Exchange doubled in value between 1630 and 1639. Construction of a system of passenger barge canals, known as the trekschuit, was begun in 1636 and there was also investment in new drainage projects during the mid-1630's.
Betting on spices...
The Dutch Republic formally began its life on January 23, 1579. with the signing of the Union of Utrecht by delegates from the states of Holland, Zeeland, Utrecht, the Ommelands, and the ridderschap of the Arnhem and Zutphen quarters. It would come to an end in March 1806, when it was abolished by Napoleon and replaced with the monarchy of Louis Bonaparte.
While spices would come to play a significant role in the success of the Dutch economy, a permanent reminder being the 'Dutch' in 'Dutch East Indies,' the Dutch Republic did not owe its existence or early survival to spices. Early success could be attributed to capitalism. So successful was the Dutch Republic at commerce and trade, that it could have served as the poster child of the free market. While the Dutch would not enter the spice race themselves until 1594, when they formed the 'Compagnie van Verre,' or Long-Distance Company, they had been involved in the spice trade through their dealings with the Portuguese much earlier than that. In 1501 the Portuguese had set up an exchange in Antwerp following the return of Pedro Cabral's expedition. By 1595, Amsterdam was beginning to overtake Hamburg as the European distribution center for spices.
In May 1599, four Long-Distance Company ships, (out of eight the company had sent out in 1598), under the command of Jacob Cornelisz. van Neck, returned to Amsterdam from the Indies. The spices carried by the ships would earn the company a profit of 400 percent. The demand for spices had a long history, with dependable returns easily understood by investors, yet the extraordinary profits earned by the voyage may have fueled an irrational optimism, even complacency, about future earnings potential. Like the victims of Tulipmania or the South Sea Bubble, Dutch investors in 1599 convinced themselves that spices represented a 'sure bet,' when it came to making a profit.
To test their theory, the Dutch would form another seven companies in 1599, increasing the number of fleets to fourteen, totaling 65 ships, in the fall of 1601. The result was that the market for spices, which seemed insatiable in 1599, had become saturated by 1601, causing a fall in prices, which, in turn impacted profits. The promise of an unending source of wealth was extinguished. Market saturation was not a problem unique to Dutch merchants. When the ships of the first English East India Company returned to London in 1603, carrying a million pounds of pepper, the price of pepper dropped. The fact that James I had acquired his own shipload of pepper did little to reduce the supply. (He did forbid the East India Company from selling its supply until his was gone, which probably restored the price, even if it temporarily forced the company out of the market.) Pepper sales were also slowed by London's plague, which motivated merchants to leave the city. Surplus supplies and falling pepper prices would prove to be an ongoing problem. Where London prices had been twenty-six pence a pound in 1601, they would be only seventeen pence in 1627.
The Dutch solution was the United East India Company (Verenigde Oostindische Compagnie or VOC), a chartered, joint-stock company overseen by a federal board of directors. While private investors were free to buy stock in the VOC, it held a monopoly on trading rights. With military and diplomatic powers, the VOC was something more than a commercial enterprise. If the troops and naval warships were seemingly independent, they were ultimately subject to the authority of the States General. When negotiations leading to the formation of the company began at The Hague in December 1601, the biggest stumbling block was the makeup of the seventeen-member board, which would come to be known as the Heren XVII. Amsterdam's directors argued that they should receive half the seats, since their merchants were contributing half the capital. Holland's Advocate, Johan van Oldenbarnevelt, was unwilling to grant Amsterdam a majority block, but did concede them eight seats.
Allowing only one company to trade in the East Indies solved the economic problem of market saturation, insofar as the Dutch had contributed to it. The next goal was to eliminate the foreign competition and create a monopoly. Portuguese settlements in the Indonesian 'Spice Islands' became the first victims of a policy of military expansion. Ternate, Tidore, and Amboina were captured in 1605. Jan Pietersz. Coen captured Jakarta (renamed Batavia) in 1619. By 1623 they had forced the English out of the Spice Islands. In 1641 they would capture Malacca, on the Malay peninsula. Ceylon, with its cinnamon production, would be taken from the Portuguese in a twenty-year campaign. Batticaloa and Galle would be taken between 1638 and 1641, Colombo would be captured in 1656, and the remainder of the island subjugated between 1657 and 1661. Their Cape colony would be established in South Africa in 1652. While not gaining total control of India, they remained the dominant power after 1660 for some sixty years. Until 1658, when they captured the Portuguese fortress of Tuticorin, on the tip of southern India, their Indian conquests had consisted primarily of Pulicat (Fort Geldria), which had been established in 1613. In 1660 they would capture Masulipatnam, followed by Cannonore in 1662 and Cranganore and Cochin in 1663. They had tried, but failed, to take Goa from the Portuguese, in 1639.
The beginning of the Nine Years' War (1688 - 1697) marked the end of Dutch economic expansion. During the 1720's the 'rich trades,' which included the Indies spice commerce, began to collapse. In 1795 the British would take their South African colony, which would be followed by the loss of Dutch Ceylon to the British in 1796. The British would take the Banda Islands from them in 1810. Returned in 1817, the British would effectively end the Dutch monopoly on nutmeg by taking some seedlings with them for transplantation to Ceylon and Singapore.
What proved the economic undoing of the Dutch was a shift in demand. European households wanted cotton, muslin, silk, tea, and coffee more than they wanted East Indian spices. Dutch warships had intimidated local chiefs and driven the English out the Spice Islands, but they could not be everywhere. The Dutch lost ground, and territory, in the Americas. Brazil rebelled in 1645 and two expeditions, one in 1648, another in 1649, were defeated in separate battles at Guararape and failed to recover the lost territory. The one remaining Dutch stronghold in Brazil, the city of Recife, surrendered in 1654. New Amsterdam (Manhattan Island) in North America was surrendered in 1664.
Market forces trump everything...
Market forces have a way of intruding at inconvenient times and in unexpected ways. Dutch expectations were that hard work would deliver the spice trade into their hands, while a spice market, with unlimited demand, would serve as a never-ending source of wealth. The 1601 price drop was a rude awakening which, while it prompted the formation of the VOC, perhaps should have made a deeper impression. The market, at times, seemingly had a mind of its own, and market saturation was just one hazard it could spring on the unwary. Conflict with other nations could upset plans, either in the form of trade wars, or more seriously, in the form of open warfare. However successful the Dutch military proved against rival powers, when its goal was the protection of markets, it was serving a master which was not necessarily trustworthy.
The Dutch trading mentality was a complex mix of idealism and reality, even brutality. In some areas they succeeded by following free market or capitalist principles, meaning success was the result of hard work, open competition, and superior products. Success in the Baltic grain, timber, and fish 'bulk trades' had involved cost-cutting resulting from the use of low-cost vessels and smaller crews. Dutch products were in demand throughout Europe as much for their relatively low-cost as for their superior quality. In other areas however, the Dutch relied, not on integrity or accepted rules of fair play, but on brute force.
Market risks, foreseen, and unforeseen...
The South Sea Bubble and Tulipmania have come to represent the ultimate in unrealistic expectations and human folly. In contrast to Tulipmania, the market itself was seen as the embodiment of rational thinking. Sound investment decisions were as close to reality as it could possibly get. In the final analysis however, such faith in the market may not have been any more rational than the belief that tulip prices or South Sea stock would continue to rise. Markets were not maintained by a physical force, such as gravity, but depended on something as flimsy as the likes and dislikes of consumers. You could depend on a market for your product, so long as the customer liked or needed it and could afford it. The Dutch spice trade was safe so long as customers wanted nutmeg more than they wanted cotton, muslin, silk, tea, or coffee.
Foreign markets and international trade were riskier because the number of uncontrollable variables increased. Demand for Dutch merchandise in England was so strong in the 1650's that consumers there stopped buying English products, causing a slump. This led to passage of the Navigation Act in 1651, and eventually to the First Anglo-Dutch War. Dutch success in the French market proved just as dangerous. Louis XIV's response was the imposition of tariffs on Dutch products in 1664 and 1667, followed by war and invasion in 1672. Losing lucrative markets through tariffs and trade embargoes represented only one aspect of market risk. There was also a risk on the import side. In 1621, Spain imposed an embargo on Portuguese salt shipments to the Dutch Republic. This contributed to a slump in the Dutch herring industry, which was dependent on Portuguese salt for its curing process.
At heart, there was an inherent contradiction in the logic of the Dutch economic argument. It was not found in their determination to monopolize the spice trade, although that goal clearly stood in stark contrast to the ideal of competition. Nor was it found in the use of force to attain that goal. They left Amsterdam armed to the teeth. More fundamentally, it was the assumption that markets were vulnerable to disruption at one location, but would operate smoothly everywhere else. The Dutch believed, in other words, that they could disrupt markets at the source, i.e., where they obtained goods, while being free from similar disruption at the destination, where they hoped to sell their products. Notwithstanding ongoing economic and military conflicts with Spain in 1600, it seemed incomprehensible to the Dutch, that other countries, such as England or France might interfere with Dutch trade or actually go to war over trade issues, as happened in 1654 and 1672.
The military problem for the Dutch was that they lacked the military resources to totally dominate potential rivals, even if they could concentrate sufficient military resources to win at limited times or places. The Netherlands were no match for the geographical size and population of France alone. Technologically, England was beginning to overtake the production capabilities of the Dutch. While the unexpected military successes of the Dutch against both the French and English were proof that their military resources were formidable, the French invasion of 1672 was a warning that a permanent war footing was unsustainable.
Competition may have been a form of warfare, but war itself represented the ultimate risk. A state of actual war, in the final analysis, was incompatible with trade and commerce, which placed a premium on the elimination of risk. The Dutch were willing to go to war to protect their markets, but at times the markets they were dependent on were those of the nations they were at war with, and a permanent state of war was not an environment conducive to trade.
Suggestions for further reading.
Malcolm Balen, "The Secret History of the South Sea Bubble: The World's First Great Financial Scandal," Fourth Estate, HarperCollins Publishers Inc. (New York 2003).
Stephen Brumwell and W. A. Speck, "Cassell's Companion to Eighteenth-Century Britain," Cassell & Co., (London 2001).
Charles Corn, "The Scents of Eden: A Narrative of the Spice Trade," Kodansha America, Inc., (New York, NY 1998).
"The Encyclopedia Americana, International Edition," Grolier, (Danbury, CT 2002).
Jonathan I. Israel, "The Dutch Republic: Its Rise, Greatness, and Fall 1477-1806," Clarendon Press, (Oxford 1995).
John Keay, "The Honourable Company: A History of the English East India Company," Macmillan Publishing Company, (New York, NY 1991).
Charles P. Kindleberger, "Manias, Panics, and Crashes: A History of Financial Crises," (Fourth Edition) John Wiley & Sons, Inc., (New York, NY 2000).
Charles Mackay, "Extraordinary Popular Delusions and the Madness of Crowds," Crown (1841).
Giles Milton, "Nathaniel's Nutmeg or, The True and Incredible Adventures of the Spice Trader Who Changed the Course of History," Farrar, Straus and Giroux, (New York, NY 1999).
Anna Pavard, "The Tulip," Bloomsbury Publishing, (New York, NY 1999).
Antony Wild, "The East India Company: Trade and Conquest from 1600," The Lyons Press, (New York, NY 2000).