Frehen R., Goetzmann W. and Rouwenhorst G. (2009) Why invest in the bubbles?

Frehen, Rik, William Goetzmann and Geert Rouwenhorst (2009) “New Evidence on the First Financial Bubbles”, Yale international Center for Finance, Working Paper 04, 24p.

Picture 8Picture 10Picture 9

This article is available online.

Why did investors decide to bet on the various companies that would form the three 1720 bubbles in France, England and the Netherlands? (p.1). How did these bubbles affect companies which unlike the Compagnie des Indes and the South Sea Company were neither involved in the Atlantic trade nor in public finance?

“Cross-sectional variation in stock returns of the 1720s may […] reveal the basis for the investor aspirations that created the bubble – whether rational or not.” Primary sources being unavailable, the authors use share prices for 1720 published in a Dutch newspaper, the Leydse Courant (p.2).

An analysis of the data thus provided indicates that in England some maritime companies (Royal African Company, Royal Exchange Assurance and London Assurance) bubbled even more than the South Sea Company (p.6). Moreover the share price of the two insurance companies went on growing for two full months after the South Sea Company share prices had reached a plateau. The share price of other companies (chief among them, the Bank of England and the East Indies Company) was hardly affect by speculation.

Picture 11“The difference in scale and timing suggests that there was more than one driver of investor enthusiasm [in] 1720, and that not all company shares benefited equally from speculative demand” (p.7). In the Netherlands, a fairly similar process was at play: investments in the West Indies Company increased by a factor 7 in the last 6 months of 1720, while the VOC share prices hardly evolved over the period (p.8). This seems to indicate that investors were driven by high expectations in regard of future profits from the Atlantic trade in the three countries considered.

However the three bubbles did not grow nor bust at the same time, thus the Atlantic Fever traveled from a financial center to another but the three bubbles may not have been linked otherwise than through the flow of capital from one centre to another when one of them burst (p.9). The rise of the WIC share prices indicates that it was the Atlantic trade that fueled investors’ interest, not the refunding of government debt part of the operation (debt-equity swap) that took place in France and England (p.10).

Picture 12Even excluding the big firms whose future successes in the eyes of the investors may have been linked to their political connection, it remains evident that the exuberance was driven by certain industries, for instance the insurance bubble may have been as much as twice the size of the South Sea Bubble (p.12).

Table p 12

The bubble in Amsterdam was smaller than the one in London, however, like in London it involved a great deal of young small firms along with the large and ancient WIC. At the end of 1720, as share prices collapsed so did liquidity and by December the number of documented transactions dropped suddenly (p.15).

Tellingly, the 1720 Bubble Act, designed to tame financial markets, was not directed to the South Sea Company but to the large insurance corporations. In the Netherlands too insurance companies were at the core of the speculation (p.16).

Disclaimer: this summary is written by the contributors of the blog and not by the author of the article. Any mistake is Manuel’s fault (and he shall be punished). It should also be noted that this is a working paper and should be taken as such.

3 Responses to Frehen R., Goetzmann W. and Rouwenhorst G. (2009) Why invest in the bubbles?

  1. you have some really good posts here. Im going to spend the next few days reading them. i love your writing style and I’m really happy to visited your blog. keep those posts coming

  2. hi friend,

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    Thanks and good luck.

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