What Can Crypto Enthusiasts Learn from History?

As Biden took office in January 2021, U.S. financial markets started a wild climb that saw record highs for the S&P indexes and benchmark Dows. Market historians and analysts for financial institutions and businesses alike, even for the online casino South Africa market have been watching the price-to-earnings ratio climb to levels associated with market panics which is leading to comparisons to the Black Friday crash of 1929. 

In 2016 Robert Schiller wrote in the New York Times, “people played the market as a grant game abetted by technological innovation and new mass media.” Many observers are suggesting that the boom, when viewed in combination with the wild ups and downs of today's cryptocurrency, have a parallel to the South Sea Bubble of the 18th century and that the lesson shouldn't be lost on today's investors.

South Sea Bubble

The South Sea Bubble began in 1720, in the earliest days of financial capitalism, and, at heart, reinforce the notion that it's not market failures, but rather individual mistakes that produce crashes. The historical account revolves around differing approaches to deciding what the market is worth. In the end, the crash that resulted from the adventure points to the pathology that causes such disasters.

The story begins in January 1720 when the British government struck a deal with the South Sea Company, a trading company that was trading in slaves and goods from South America.

The South Sea Company was lending money to the British Treasury and, in return, was receiving a monopoly of the kingdom's South American proceeds.  The deal allowed the Company to exchange new shares for British government bonds which the British government had issued to cover the debt accrued by three decades of war.

By agreeing to swap bonds for shares, bond-holders would be charged a lower payment than their regular bond payments and would also be eligible to claim some of the profits from the trans-Atlantic trade.

South Sea shares started to climb as soon as news of the deal leaked. Within 3 months the shares' worth tripled but no one was suspicious. Journalist Daniel Defoe, the author of Robinson Crusoe, wrote "the present rate of stock is far from being exorbitant." He urged boldness, saying "A man that is out of the stocks may almost as well be out of the world."

Demand Increases

Throughout the spring of 1720, demand for South Sea shares accelerated. It reached its peak in late June at £1,000 (more than £100,000 in today's currency), having shot up almost nine times its original worth. With a little bit of skepticism, it would have been possible to see that the price represented by South Sea shares for the actual economic activity was unsustainable and absurd. But, say some, shouldn't someone have seen that a crash was imminent? 

One person that did was Archibald Hutcheson who was a member of Parliament and a fellow of the Royal Society. In the spring of 1720 Hutcheson built a mathematical model that could calculate the income that the South Sea Company would have to take in in order to be able to make the amount of money that it would need to justify its stock price.

Hutcheson's model showed clearly that the South Sea Company was in a bubble. By selling shares at its mid-April level of £300, Hutcheson found that it wasn't plausible that the Company would be able to trade enough to justify that price.

He repeated the calculation over and over as the market climbed. His model showed a widening gap between the likelihood that the Company could earn enough to cover the stock price. There were other, safer investments, such as government bonds, that made more sense. But investors raced to convert those bonds into Company stock.

Hutcheson tried to warn the public but no one would listen. He wrote that given "this blazing and astonishing meteor," a mathematical model was no match for the excitement. As South Sea shares exceeded £500 Hutcheson acknowledged that "people… may then begin to think more coolly about this Matter, and hearken a little to Reason and Demonstration."

Reckoning

Hutcheson's model was based on the work of the mathematician, Isaac Newton. Besides watching an apple fall, Newton was an experienced investor who had shares in the East India Company the South Sea Company and the Bank of England. But even though Newton had created much of the mathematics that Hutcheson used to describe change over time and even though he was initially cautious, he was caught up in the frenzy. Newton continued to buy shares in the South Sea even as shares approached £1,000.

Psychologists have written about the phenomena of how otherwise rational people become overwhelmed with money manias when they experience or witness sudden gains. Then, as now, the appearance of sudden wealth can seem normal and permanent and entice people who would otherwise be more careful.

Observers have noticed that the experience is similar to the draw that people feel to casino gambling - they are attracted by the emotional power of money... the chance to win big even though they engage in behavior that seems risky.

Collapse

By early October 1720 the South Sea Company's shares had lost 70% from their highest value. By December they were back to their pre-bubble levels. Newton's other investments cushioned him but thousands of investors went bankrupt. He told his niece, "I can calculate the motion of heavenly bodies, but not the madness of people."

Hutchenson was able to show that it is possible to quantify questions of value and risk. That's something that investors in 2021 must remember. Cybercurrencies in particular are seeing wild fluctuations and it's drawing some people in who should know better. It's true that the investments are the result of individual choices but it's important to remember that finance needs regulation to control foolish behavior during market extremes.

Today, the question is, is the cybercurrency market being adequately regulated?