Riding the bubble on low interest rates: evidence from the South Sea
Over the past years, a growing number of economists have become convinced that a new era has started – one characterized by unprecedentedly low interest rates. As a result, pundits discuss many disruptive effects inherent to this evolution.
Such as: negative deposit and mortgage rates, all-time high stock and bond market levels and underfunded pension plans. In a new study, I, together with Fabio Braggion and Emiel Jerphanion, relate low interest rates to stock market speculation. More specifically, we test whether access to cheap credit induces speculative behavior among investors.
Despite its importance, this question is virtually impossible to answer because there can be many reasons why investors behave in seemingly reckless ways. Moreover, it is impossible to link an investor’s share trades to credit positions because we simply do not have such data.
the South Sea or Mississippi Bubble
In this new study, we address these problems using meticulously recorded eighteenth century data. We use so-called ledger accounts which record daily stock transactions and loan positions for each individual trader in the British market from 1715 to 1725. [We collect trades for the Bank of England, East India Company and Royal African Company. Three of the largest shares available in the British market at that time. We also collect subscription lists for the South Sea Company and London Assurance.] Our database consist of more than 15,000 traders and contains a wide spectrum of investors - for example Sir Isaac Newton (see his share sales below), George Frideric Handel and Elihu Yale (the founder of Yale University). We study their trading behavior during a frenzy that is better known as the South Sea or Mississippi Bubble. A price run up and collapse of historical proportions like the tulip mania and bitcoin bubble (see Figure 2 below).
Figure 1: Isaac Newton’s Bank of England share sales in 1720.
A bubble typically draws much attention from a broader audience than investors. The imagination of gaining a large returns over a short interval attracts many. While economic theory advises against riding the bubble - buying stocks with large price increases over the past days – many investors cannot resist the temptation. We trace every individual investor over the course of the bubble, and can therefore measure each trader’s gains (losses) in an accurate manner. We find that investors who borrow money are more likely to ride the bubble. Loanholders are more inclined to buy shares that caught their attention with price run ups over the past days and are also more likely to subscribe to new issues of highly overvalued stocks. As a result of these risky strategies, the average loan holder incurs large losses. We thus show that credit-induced speculation inflated the bubble and therefore contributed to the calamities that resulted from its burst. Hence, easy access to credit may imperil financial markets in the long run.
Figure 2: A historical comparison of bubble scales, from The Economist (2018). “The threat of tough regulation in Asia sends crypto-currencies into a tailspin”.