ADVERTISEMENTS

The 21st century has seen its share of efforts to extend the power of the state to regulate economic activity in new and increasingly comprehensive ways.  The economic scandals at the start of the 21st century and the economic collapse of 2007-2008 provided national governments, and international organizations more than enough excuse to push ambitious agendas for control.   Underlying these efforts are notions of fairness, investor protection, fairness, and the protection of the integrity of markets.    The conventional narrative of the organization of economic activity is founded on notions of legitimacy tied to law and the central role of legislator, administrator, judge and lawyer in the management of economic activity. See, Larry Catá Backer, From Narrative to Narrator: Remarks at "Business Law and Narrative Symposium" at MSU, Law at the End of the Day,  Sept. 16, 2009.  In the absence of this public oversight, commercial activity is suspect, markets lose their integrity and  organized economic activity loses its welfare maximizing effects.  A recent story and an old scandal remind us that the narrative of state intervention in markets through regimes of positive law may be as much about the preservation of the power of the state as it is about the objects of regulation.  In the absence of state intervention is may be possible to run credible capital markets.  At the same time, markets in a highly regulated environment may produce the greatest corruption of systemic failure.

The recent story describes the development of capital markets to fund the increasingly lucrative business of piracy, currently centered in Somalia.    In a country without a credible state apparatus, and little by way of effective positive law, a credible market based economy may be elaborated without the intervention or management of the state.

But the converse is not true--that state regulation can prevent or manage market activity and protect the integrity of capital markets.   The story of the South Sea Bubble is worth recounting after the collapse of 2007-08.  It serves as a reminder that state may not be the answer.   This story is drawn from the masterful account in Malcolm Balen, A Very English Deceit:  The Secret History of the South Sea Bubble and the First Great Financial Scandal, (London:  Fourth Estate, 2002).

The 21st century has seen its share of efforts to extend the power of the state to regulate economic activity in new and increasingly comprehensive ways.  The economic scandals at the start of the 21st century and the economic collapse of 2007-2008 provided national governments, and international organizations more than enough excuse to push ambitious agendas for control.   Underlying these efforts are notions of fairness, investor protection, fairness, and the protection of the integrity of markets.    The conventional narrative of the organization of economic activity is founded on notions of legitimacy tied to law and the central role of legislator, administrator, judge and lawyer in the management of economic activity. See, Larry Catá Backer, From Narrative to Narrator:  Remarks at "Business Law  and Narrative Symposium" at MSU, Law at the End of the Day,  Sept. 16, 2009.  In the absence of this public oversight, commercial activity is suspect, markets lose their integrity and  organized economic activity loses its welfare maximizing effects.  A recent story and an old scandal remind us that the narrative of state intervention in markets through regimes of positive law may be as much about the preservation of the power of the state as it is about the objects of regulation.  In the absence of state intervention is may be possible to run credible capital markets.  At the same time, markets in a highly regulated environment may produce the greatest corruption of systemic failure.

The recent story describes the development of capital markets to fund the increasingly lucrative business of piracy, currently centered in Somalia.    In a country without a credible state apparatus, and little by way of effective positive law, a credible market based economy may be elaborated without the intervention or management of the state.

Yet it would be foolish to consider this as a marginal story.  The issue of the piracy and its economic aspects affects states without governments, like Somalia, as well as states with well formed and strongly regulatory governments.  The issues underlying piracy touch on economic trade disparities and market advantage.  "In many ways, the Somali pirates exemplify what the British historian Eric Hobsbawm referred to as "social bandits," outlaws who, drawing on community support, use criminal methods to challenge prevailing hierarchies of power and wealth. One doesn't have to romanticize the pirates to see that there is a quasi-political element to their actions."  Rubrick Biegon, Somali Piracy and the International Response, Foreign Policy in Focus, Jan. 29, 2009. And pirate financing appears to have been naturalized into at least a small part of global capital markets.  "It has been reported in the past that wealthy businessmen in Dubai were financing the pirates. But the BBC's Somali Service says these days it is the businessmen asking the pirates for loans." Robyn Hunter, Somali Pirates Living the High Life, BBC News Online, Oct. 28, 2008.

But the converse is not true--that state regulation can prevent or manage market activity and protect the integrity of capital markets.   The story of the South Sea Bubble is worth recounting after the collapse of 2007-08.  It serves as a reminder that state may not be the answer.   This story is drawn from the masterful account in Malcolm Balen, A Very English Deceit:  The Secret History of the South Sea Bubble and the First Great Financial Scandal, (London:  Fourth Estate, 2002).

The similarities of the current economic situation in the United States and the economic collapses in England 1720 and France 1719 are striking. A careful read might find you checking and then re-checking the copyright on The Secret History of the South Sea Bubble, just to make sure Balen?s historical perspective or re-telling of events had not been skewed by the crash of 2007. Central themes of ?rescue packages?, ?saving banks? and ?corruption? are all too familiar in this book. The copyrights were in fact in 2002 and 2003, an eerie reminder to the axiom of history oftentimes repeating itself. It is evident that Balen could foresee the United States? economic ?bubble? growing to an unsustainable size with the quotes of overconfidence from 1999-2001 he chose to preface each chapter.

The book begins with meticulous description about the atmosphere surrounding the building of St. Paul?s Cathedral in London, 1710. The people?s worship was said to be of money, not God. The architect, Christopher Wren, designed the top of the cathedral to resemble a sort of bubble which was so delicate that it needed a second inner bubble to support it. The economic scene included bank rivalries and stock jobbers in Exchange Alley. The bubble on the cathedral is symbolic of the era and fragility of the stock market investments when they grow to an unsustainable size.

John Law, the instigator in Frances? economic collapse of 1719, was originally from Britain. Law fled the country early in his career after he was involved in a dual, which left the other participant dead. The dual was over a lady acquaintance and much of the details are left up to the imagination, sadly one of the most interesting background descriptions in the book. During his years abroad, Law made a fortune as a gambler and acquired a taste for finance. He observed the Bank of Amsterdam and their currency system. In a time where coins were frequently clipped and instantly devalued, Law had the radical idea of paper money whose value was backed by land.

Law attempted to persuade a few countries of his idea, and finally found a taker in France where the national debt was at an all time high of three billion livres. The country was desperate and decided to give Law a shot in 1716. France would join the club of only six other countries that used paper notes at the time. Law created a bank that would issue paper notes and also act as a trading corporation to buy and sell property. It would lend money at a fixed rate of interest and the gold and silver in the ducal treasury would act as its reserves. Law created the Mississippi Company who sold shares to investors hoping to capitalize on the rich mineral prosperity of Louisiana and Mississippi. He deported the sick, prisoners and low income citizens to cultivate the land after having no other volunteers. Needless to say his empty promises of returns on land development in America popped France?s economic prosperity like a bubble. Where people had once rushed to buy stock because the prices were rising so quickly; they could now practically use the paper currency for toilet paper as it lost almost all its value. The Plague followed soon after, which many French citizens viewed as punishment for their foolish admiration of investing in the get rich quick schemes.

John Blunt made his reputation through his idea of using lottery monies to help pay off the national debt in Britain. He and his partner, who was involved in the government, would sell tickets with a certain number of guaranteed winners. Although, the lottery was briefly successful, Blunt saw a potentially bigger return through buying the country?s debt and selling stocks. Blunt used the Sword Blade Bank to create the South Sea Company, which was initially supposed to be a trading company but never actually generated a profit. The South Sea Company was the front for the stocks in 1720 and filtered money through the bank, where citizens would buy at a days? rate and as the company grew, the stocks would increase. Blunt was much more underhanded than Law, and bribed many government officials with free stock or highly discounted prices. The Company went through four different phases of selling stock, each time at a higher price, and many people made money hand over fist. Blunt issued generous credit and payment plans and kept little money in the reserves. When the word finally spread that The South Sea Company was collapsing and wasn?t actually based on trading or any sort of real income producing business, it was too late and the stock dropped well below what most people owed. Instead of an actual business plan or improved method of business, such as Law?s paper notes having value backed by land or gold, Blunt had made millions on his ability to corrupt government officials and inflate stock prices.

Most of Britain?s government officials and the King?s party had dirty hands, which made rectifying the economic collapse difficult. Robert Walpole, one of the only objectors to The South Sea Company buying the government?s debt, saw his opportunity to seek revenge on his political enemies and take control of the chaos. Walpole was able to save the monarchy and the masterminds behind The Company to create political leverage, while at the same time persecuting a minority of government officials who had received bribes to satiate the blood thirsty public. With this power he was able to put friends in recently vacated government positions and secure control over the country.  The parallels to the events of 2008-2009 are worth considering.

Plague provided the excuse.  Fear of contracting France?s plague caused England to quarantine its? ports, leaving dozens of ships unable to unload their cargo. Churches were attempting to regain ground it had lost through the stock explosion by condemning those who had fallen weak to money and the Plague was their punishment. ?Walpole had calculated that he needed the crisis to run out of control, and for the anger of investors to grow and be heard ever louder, in order to pitch the ruling duopoly?out of power?? Walpole sought political power and revenge against his colleagues. He aimed to sweep out the corruption, but not too far or else he himself could be entangled. Walpole began working out his new rescue deal with the Bank of England and then presented it to the King before the House of Commons. He aimed to show his support of his party and the King enough so that they would have favor with him before, for lack of better words, shit hit the fan. Walpole?s new plan included both the Bank of England and the East India Company acquiring a quarter each of the South Sea stock, and each would offer some of their own stock to annuitants in exchange for South Sea shares. Therefore, at least shareholders would own shares in reputable businesses.

When the plan was presented, Parliament was thirsty for blood and would not be satisfied until people were found to blame.  ?Parliament began to flex its muscles, as the full scale of corruption began to emerge, Walpole would maneuver to undermine the actions of his parliamentary colleagues without leaving any evidence of his involvement in the cover-up he had orchestrated.? The Commons immediately formed an inquiry committee to investigate the South Sea Company. The Parliament wanted everything accounted for starting from December 1719, but it was too late the South Sea Companies cashier Robert Knight was already orchestrating a cover-up. Knight took steps to erase and fill in holes with fake names in the accounting ledgers where they had recorded the bribes and discounted share offerings.

When Parliament reconvened in January 1721 after the Christmas break, Walpole had promised to protect some, and was waiting for the opportune moment to guide the direction of the inquiries. The House of Commons then required that the South Sea Company?s Directors pay £25,000 in bail money and were presumed guilty until proven innocent. The worst sanction yet, would be the Commons? refusal to appoint the Director?s lawyers. Trials were held in both the House of Lords and the Commons against the Directors of the Company. In the hustle and bustle of organizing the trials and deciding who and how those involved should be punished, Knight knew the stacks of evidence he had been keeping in his office would soon be discovered. ?As the days went by in the run-up to [Knight?s] own appearance before the Commons? inquiry, Knight desperately approached government ministers to try to blackmail them into protecting him.?  In Knights questioning he kept silent about the Company?s dealings, and planned his escape with the ledger in tow. Knight had transferred enough money to live on to foreign banks in his preparations, and when word spread of his departure it ?stripped away the veneer of official respectability which had masked the Company?s disreputable dealings over the past year, so that the Commons saw for the first time the true nature of the South Sea enterprise.? The country was in an uproar and demanded that Knight be caught. The ministry continued to clean house by stripping all directors in the Company of their public offices, except of course the King, and continued to imprison and seek restitution from others. The most unexpected turn of events was when Blunt caved and told the inquiry committee everything, even names of government co-conspirators.

Walpole now feeling things have utterly spiraled out of control, enters the scene from stage left, and begins to play the game. ?While Walpole publicly protested that he wanted Knight to be extradited, and that he was doing everything he could to make it happen, behind the scenes he had resolved to keep him abroad at any price, rather than bring him back to give evidence.? Walpole knew that if Knight came back, the King would be incriminated; therefore it was in Walpole?s best interest to keep the Kings favor in his pocket. As it happened a British police officer in Brussels tracked down Knight, not knowing the true intentions of the King, and placed him inside the Citadel of Antwerp. The ledger was sent back to London, but was mysteriously lost en route. Walpole?s political dance continued and protested that Knight be returned to London, at the same time at the behest of the King a special envoy was sent to Vienna. Colonel Charles ?Churchill had been ordered to persuade the Governor of the Austrian Netherlands?that Knight?s extradition posed insoluble difficulties for the British government. The delay of Knight?s return continued, and the measures taken to conceal Walpole and the King?s true intentions were extreme. Finally in September 1721, a letter was written on behalf of the King stating ??[the King] is pleased to express the wish that Your Excellency should order the Governor of the Antwerp Citadel to enlarge Knight from confinement, allowing him not only to have liberty to walk on the Citadel, but to escape?? Thus, the Emperor released Knight to live in exile abroad, where he would remain for many years.

Walpole then began strategically placing his friends and family in the government offices vacated by the South Sea scandal. February 1721 marked the beginning of the end for the committee?s inquiry, when they presented their initial findings to the Commons for a full 2 ½ hours. They revealed actual worth of stock and what it had been sold for, and ?unraveled the process by which shares had been ?sold? for notional prices with no record of a date and without any money changing hands?? The committee reported that the Company had gone well beyond bribery and corruption, but that ?there were no financial checks and balances placed upon it by Parliament, despite the fact that it had taken upon itself the role of guardian of the nation?s finances through its purchase of the national debt.? The Commons began to prosecute and sentence those revealed to be involved in accepting the bribes, and Walpole maneuvered once again to save those he felt important.

You may be asking yourself, what happened to Blunt and Law? By a vote, Blunt was allowed to keep just £1,000 (which was later raised to £5,000) and ?retire to Bath to contemplate the ashes of his career.? By April 1722, Walpole had secured his anticipated control in government. He oversaw both ?the Lords and the Commons and established Whig supremacy for a century.? Law was finally allowed to return home to London, by Walpole?s granting, and later died in Venice at age 58.

Both the story of governmental collusion in regulated markets in the crude for of the South Sea Bubble of the early 18th century and the modern story of the rise of unregulated capital markets in pirate activities remind us the simple binary relationship of private economic activity and public regulation may not provide either the legitimacy or integrity necessary to preserve a welfare maximizing framework.   Moncentric governance evidences both its thrust--to acquire power, and its limits.  It suggests that value of recent powerful efforts to try to fashion forms of polycentric governance.  See Larry Catá Backer, On Challenges to Operationalizing a Transnational Framework for Business and Human Rights--the View From Geneva, Law at the End of the Day, Oct. 13, 2009.

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