Isaac Newton and the perils of the financial South Sea (2024)

https://doi.org/10.1063/PT.3.4521

The literature on the South Sea Bubble is voluminous,2 but many of the existing accounts are faulty. For example, some inaccurately claim that the South Sea Company was a fraudulent enterprise from the start, or that it collapsed after the crash of the bubble in the fall of 1720. The truth, as usual, is far more complicated.

The South Sea Company was established in 1711 to deal with a pressing financial problem. The British government had a large backlog of unpaid bills, largely from contractors supplying the British military during the War of the Spanish Succession. The government offered its creditors South Sea stock, a product similar to shares in a modern corporation. The stock did not promise full repayment of the money creditors were owed, but it did promise them regular payment of interest.

The South Sea Company received the funds from the government to pay that interest to the creditors. The company also held a monopoly on British trade with the west coast of the Americas and part of the east coast of South America—hence the name “South Sea Company.” The company profited from the sale of some British goods and, more significantly and more grimly, enslaved Africans. The enterprise enticed investors with the promise that profits from trade in the South Seas would add generously to their interest payments.

During the late 1710s, the South Sea Company was a rather dull operation that simply passed the government’s payments to its investors. Scholars don’t have solid information about the profitability of its trading activities during that period; the evidence strongly suggests the company’s commercial operations lost money in those early years. However, the trade monopoly helped inspire dreams of future riches among the public. Newton, who also owned government bonds and some investments in the Bank of England, was an early investor and added to his stake as time went on. His South Sea investment was initially quite profitable; the prices of financial securities increased as the long period of draining wars ended and peacetime economic activities began to grow.

The economic recovery of the late 1710s inspired a new vision for the South Sea Company. The British government announced that the company would take over most of the British national debt in 1720. The result was the South Sea Bubble. The price of South Sea stock soared through the summer of 1720, and then it underwent a precipitous collapse in September, most likely because investors began to realize their profit expectations were unrealistic. By October, the stock was worth less than a quarter of its peak price (see the box on page 33).

But the collapse was not the end of the South Sea Company. After some financial restructuring, it continued to exist until the middle of the 19th century, almost exclusively as a private agent handling the paying out of government funds to holders of the national debt. Those who bought South Sea stock before mid 1719 and simply held onto it for a few years prospered, as they were rewarded with a roughly 50% capital gain on top of generous dividends. Those returns were enabled in part by the company’s financial moves in 1720, which amounted to a Ponzi scheme that rewarded early investors with money from new investors.

In 1720 Newton was almost 80. His significant scientific achievements were decades in the past, and he was not doing any original research. Even so, he was active. He had left his academic position at Cambridge University to become the warden of the Royal Mint (figure 2) in 1696, where he played an important role in carrying out the great recoinage of the 1690s. In 1699 he became master of the Mint, and he would remain in that post until his death in 1727. He continued to lead the Royal Society as its president and was a celebrity that foreign dignitaries visiting London were eager to meet. Both private individuals and the British government called on him for technical advice on various problems, such as finding longitude at sea. His physical and mental decline apparently started after 1720, as Richard Westfall details in his authoritative biography.3

Newton was also wealthy by the standards of the day. Master of the Mint was a lucrative post. His position at Cambridge had paid about £100 per year; by contrast, his earnings at the Mint, including both a salary and a fraction of the Mint’s production of coins, averaged close to £2000 per year. By 1720 he was also earning well over £1000 per year from dividends on his investments. His total annual income of more than £3000 put him in the top 1% of the population, and not far from the top 0.1%. He was recognized as a member of the British elite and lived well, with a horse-drawn coach and a retinue of servants. But he did not overspend, was charitable, and saved a substantial fraction of his earnings.

Land ownership was the traditional marker of British wealth and social status. Newton, however, never acquired any significant real estate. He was among the first to put his money mainly into financial instruments, a relatively new possibility at the time. His investments were primarily in government bonds and in securities of large joint stock companies such as the Bank of England and the South Sea Company.

Newton’s net worth shortly before the South Sea Bubble started was just over £30 000. That is also the approximate value of his estate at his death in 1727, so the bubble hardly ruined him financially. However, he did lose a substantial amount. After making an early profit of about £20 000 in the early stages of the bubble, Newton put nearly all his money into the doomed venture. By mid 1721, his net worth was down to about £20 000; he had lost all his early profits and a good bit more besides.

Our knowledge of Newton’s finances appears to be fairly complete for the period after the crash of the South Sea Bubble. Deducing what Newton did during the crucial period in 1720, however, involves making inferences from incomplete data. The box above summarizes what we know about Newton’s investments in the South Sea Company over the course of 1720. At the start of that “fatal year,” as it was almost universally called for some time after the crash, slightly less than half of Newton’s assets were in South Sea stock; the rest were in government bonds.

The two vertical lines marked “Newton sells” represent two instructions he issued in April 1720 for the sale of his South Sea stock; the horizontal line represents a period during which Newton was acquiring a large holding of British government bonds. Based on his overall wealth, we can assume that the money for that came from the liquidation of his South Sea stock.

It appears that in June of that year, Newton liquidated almost all of his newly acquired stake in government bonds and used the proceeds to buy South Sea stock. That move is shown in the first of the four vertical lines marked “Newton buys”; the other three vertical lines denote documented instances when Newton either bought South Sea stock directly or converted some of his other government bonds into it. We know he continued to pour money into the South Sea stock even as its price was beginning to slide, before the precipitous collapse in September 1720. By that time, essentially his entire fortune was invested in South Sea.

Unfortunately, we have no direct evidence of what motivated Newton’s financial decisions. However, we can obtain some additional insights by examining Newton’s involvement in the estate of his friend Thomas Hall, another wealthy civil servant who named Newton as one of the executors of his holdings. We have a complete record of the financial transactions of the estate, since the executors had to be able to account for their actions.

Newton did not make decisions for the Hall estate alone; he had to work with three other executors and consult Francis Hall, Thomas’s son and the principal beneficiary. Although the estate’s decisions do not represent Newton’s views alone, he must have been in broad agreement with the group’s resolutions, and his own thinking was surely influenced by the discussions that took place. As seen in the box, the Hall estate also invested in South Sea stock. An early purchase, apparently made at the request of Francis Hall, took place just as Newton’s purchases of government bonds were ending. The last two purchases occurred as the stock was more than halfway down its slide and show real faith in the South Sea project despite the price collapse.

Let us now consider in more detail the investment scene in April 1720, when Newton made an early decision to sell his stock. The project for the South Sea Company to take over almost all of the British national debt was presented to Parliament at the end of January 1720 and, after heated debate, accepted at the beginning of February. However, the South Sea stock price did not vary much from late March until the end of May. What could have induced Newton to sell out in the middle of that period?

My analysis of the available financial documents strongly suggests that Newton decided to liquidate his entire stake in the South Sea venture in the space of less than one week, on Tuesday and Saturday, 19 and 23 April. Those two days neatly bracket a meeting of South Sea investors on 21 April. We do not know much about what transpired at that meeting, but according to news reports, many people were in attendance for the long discussions and presentations. It could be that the meeting helped strengthen Newton’s skepticism and led him to decide to get out. Significantly, Thomas Guy, an eccentric investor who became famous for making a massive fortune in the bubble, started liquidating his stake the day after the stockholders meeting.1 Unlike Newton, Guy did not get seduced into buying back in. He kept his profits and used them to establish Guy’s Hospital, famous for its contributions to medicine in the past three centuries.

April 1720 also saw the publication of an unusually large number of pamphlets and newspaper articles about the economic fundamentals of the South Sea project, some of which Newton surely would have seen or discussed with contemporaries. On 14 April, a week after the passing of the South Sea Act, the South Sea Company offered some of its new shares to the public in the first of four sales. To stir up enthusiasm for the first sale, the company’s managers apparently arranged for the publication of an anonymous article in the newspaper Flying-Post on 9 April. The piece presented a vision for nearly infinite investor returns: the higher the price the South Sea Company could obtain for its new shares, the better its investors would fare.

The Flying-Post article reached its astounding conclusion by a certain amount of what today might be called “mathiness,” quantitative reasoning that confuses the issue instead of clarifying it. If you own all 500 shares of a company with assets of $100 000, each share is worth $200. If you then sell 2 000 new shares at $400 each, your company now has assets of $900 000 and 2 500 shares, so each share is worth $360. Modern startups often attract early investors with similar promises. But a legitimate startup will offer some justification for the increased price that new investors pay, such as a new technological breakthrough achieved with funds from early investors. The Flying-Post article offered no evidence of any new ingredient that would produce increased profits. In reality, what it was describing was an 18th-century Ponzi scheme.

Three convincing rebuttals of the Flying-Post article have survived from that period. One was authored by Archibald Hutcheson, the most famous debunker of the South Sea project. His pamphlet appeared on 21 April, the date of the South Sea Company stockholders meeting. It is possible that Newton was influenced by those refutations, or he may have reached the same conclusion himself.

But the bulk of British investors did not divest. How could people disregard the refutations of the Flying-Post puff? A letter from a prominent private banker in London, written in June 1720, nicely illustrates the fear of missing out that investors often experience during a mania: Despite his own long-standing skepticism about the South Sea project, the banker wrote that “when the rest of the world is mad we must imitate them in some measure.”4 Further, even though the math behind the Flying-Post claims was risibly fallacious, the South Sea Company’s trading monopolies remained potentially profitable.

What is most remarkable is that aside from the Flying-Post article, the South Sea managers never presented the public with a business plan explaining how they would generate substantial returns for their shareholders. In fact, I can say with confidence that South Sea promoters lacked an even halfway plausible business plan. The one they were forced to present to Parliament after the bubble burst indicated that they were planning to pay the high dividends they promised mainly out of the funds they expected to obtain from sales of shares—in other words, they had no plan beyond the misleading and overly optimistic scheme their anonymous friend or agent outlined in the Flying-Post.5 But that was not known to the public before the collapse. The mania reached a new level of intensity in June, and Newton was swept up in the groupthink that ruled the British investing public.

It is noteworthy that once Newton decided to go back into South Sea stock, he moved essentially all his financial assets into it, and he did so rapidly with a series of investments in mid-June. It seems he had become convinced the purchase was a promising venture. In contrast, the Hall estate left much of its assets in Bank of England stock. Newton’s banker and deputy at the Mint, John Francis Fauquier, also went down a different path; he did not commit all his funds to the South Sea Company, and he invested on a schedule different from Newton’s. Newton was clearly making his own investment decisions and not simply following others’ advice.

In general, Newton was intimately familiar with commodities and finance. He had to be, since his job as master of the Mint required him to make many decisions that depended on market prices and conditions. Did he also visit Exchange Alley (see figure 3), where financial dealings were concentrated in the early 18th century? The alley was not regarded as reputable, and reports of visits to it by the aristocracy, especially by aristocratic ladies, scandalized polite society. A claim exists in the literature that Newton was seen in Exchange Alley, based on a letter by the famous London publisher Jacob Tonson that mentions the possibility of meeting a “Mr. Newton” there.6 However, it seems likely that Tonson would have referred to such a famous figure by his full appellation, “Sir Isaac Newton.” So Tonson probably had another Newton in mind in his letter. (Several affluent Newtons lived in Britain at that time.)

Whether he ever visited Exchange Alley or not, we have evidence of Newton paying attention to the operations of individual companies. In a letter to his friend the mathematician Nicolas Fatio de Duillier, Newton declined to invest in a company that Fatio was promoting. He not only noted the low price of that company’s stock, he also wrote that its fundamentals were not good, since he had learned its “rents in Scotland are ill paid & difficultly collected.”7 The letter to Fatio also stated that “I lost very much by the South Sea company which makes my pockets empty, & my mind averse from dealing in these matters.” (Newton’s statement is an exaggeration, as his pockets were not empty; he was still quite rich. But his recent losses were a handy excuse.)

Thus Newton was clearly financially sophisticated. However, unlike Guy and a small number of other investors, he was not astute enough to avoid the disaster of the South Sea Bubble. In that he was part of an immense crowd—an estimated 80–90% of all British investors—who were drawn into that economic spasm. Unlike astronomy, mathematics, and physics, finance was not an area where Newton towered over his contemporaries.

The number of investors who were taken in by the South Sea Bubble reflected to some extent the relatively low level of financial sophistication in the early modern society. Investors—even experienced ones like Newton—had only recently been introduced to new financial institutions and products. On the other hand, contemporary examples abound of the investing public being bamboozled by specious visions of infinite investment returns. There is little sign that has changed over the ages.

And we should not overestimate the financial naivete of the public in the early 18th century. In Newton’s time, professionals were available to assess the value of conventional financial products. Among them was Newton’s friend Abraham de Moivre, an important mathematician who was at the forefront of the development of probability theory and actuarial science. De Moivre earned part of his income by providing advice on gambling wagers and on valuations of leases and annuities.8 In addition, frequent government lotteries spawned a subindustry of intermediaries that enabled people to vary their levels of risk by purchasing a small part of several lottery tickets.

The South Sea Bubble posed a more challenging problem. No well-defined money flows, or even probability distributions, existed. Aside from the Ponzi arguments, which deceived many, all sorts of vague rumors of flourishing trade, strategic alliances, and the like sprang and spread. Some observers, such as Hutcheson, saw they were unrealistic, but most of the public, including Newton, fell for the humbug.

Newton’s failure to discern the South Sea Bubble’s unsustainability illustrates a fact that is sometimes forgotten when we discuss him: He was brilliant, but he was not a universal genius. He did much to improve the efficiency of the Royal Mint by reducing the variation of gold coins in weight and fineness, for which purpose he formulated the cooling law that bears his name.9 He aided in setting up the Longitude Prize and he helped dispose of many crackpot submissions to the body in charge of awarding that prize, but he was wrong in his skepticism about the feasibility of using clocks in that setting.3 And, of course, he spent years on alchemy and theology, with little to show for his efforts.

That Newton was able to achieve so much in astronomy, mathematics, and physics was due not just to his own genius but to his starting that work at just the right moment, when solid foundations had been laid by the likes of Tycho Brahe, René Descartes, Galileo Galilei, Christiaan Huygens, Johannes Kepler, and Blaise Pascal. In those areas he really was able to “stand on the shoulders of giants.” In the finance of the South Sea Bubble, he was standing in a swamp, and so even his brilliance did not save him from losses.

This article is based on my paper “Newton’s financial misadventures in the South Sea Bubble,” Notes and Records: The Royal Society Journal of the History of Science, volume 73, number 1 (March 2019), page 25.

Andrew Odlyzko is a professor of mathematics at the University of Minnesota in Minneapolis. He has published in mathematics, computing, and communications and is now concentrating on the interaction of finance and technological innovation.

© 2020 American Institute of Physics.

2020

American Institute of Physics