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In 1690, the English navy suffered a devastating defeat against France at the Battle of Beachy Head.
The battle took place off England's own coast. The French fleet seized control of the English Channel, and London lay exposed to the threat of invasion. William III — a Dutchman who had become King of England through the Glorious Revolution — needed to rebuild his navy. To do so, he required 1.5 million pounds.
News of the defeat at Beachy Head reached London swiftly. France's command of the Channel meant that invasion was now feasible. A French fleet could appear at the mouth of the Thames. Merchants in the City of London began hiding their gold. Insurance premiums for shipping soared at the docks. In coastal towns, residents packed their belongings. It was the first time since the Spanish Armada, a full century earlier, that the English homeland had been directly exposed to military threat. The war was not unfolding across some distant ocean — it was being fought just beyond the shoreline. In portside taverns, in the coffeehouses of the City, in church courtyards, the same question hung in the air: what happens if the French land?
The King requested a loan from the goldsmiths of the City of London. They refused.
At that time, the goldsmiths were not merely artisans who worked with gold, despite what their title suggested. They were, in effect, London's bankers. When aristocrats and merchants deposited gold coins, the goldsmiths issued receipts of custody, and those receipts circulated in the marketplace as a form of payment. The goldsmiths' vaults were the most secure places in London, and their receipts were the most trusted pieces of paper in England. They frequently served as moneylenders to the Crown.
But it was precisely that role that was the problem. They carried a memory they could not forget.
In January 1672, Charles II had proclaimed the "Stop of the Exchequer" — a unilateral suspension of all payments owed from the royal treasury, including roughly 1.3 million pounds in principal and interest owed to the goldsmiths. No declaration of war, no negotiation — one day, the King simply announced he would not pay. The goldsmith Edward Backwell went overnight from being one of the Crown's largest creditors to standing on the brink of bankruptcy. Several goldsmiths who could no longer recover their loans to the Crown went under in succession, and depositors who had entrusted money to those goldsmiths suffered cascading losses in turn. The King's default sent a shockwave through the entire private financial system, laying bare the fragility of any arrangement built on nothing more than a monarch's word. From that point on, the goldsmiths became extremely cautious about lending to the Crown, and when they did lend, they demanded far higher interest rates.
Eighteen years had passed, but the memory in London's financial quarter remained vivid. The King's debts were personal debts. If the King wanted to borrow, he had to borrow on his own credit. And that credit depended on the monarch's mood. If he changed his mind — or if he died — the debts could simply vanish. The goldsmiths' refusal of William III's request was only natural. Lending money to the Crown was, in essence, the same problem as lending to the Duke of Burgundy in fifteenth-century Florence — a gamble dependent on a sovereign's willingness to repay.
The London goldsmiths were determined not to repeat the mistake that Portinari had made at the Medici Bank.
But war does not wait. France's Louis XIV commanded the most powerful army and navy in Europe, and his country's population and economy were both three times the size of England's. Military force alone could not win. Money was needed. And not the kind that came from the King's treasury — what was needed was an entirely new system capable of mobilizing the resources of the entire nation for war.
By 1693, the treasury had reached its limit. During the Nine Years' War (1688—1697), England's annual war expenditure had surged to between 5.5 million and 8.5 million pounds, whereas government spending under the previous monarch, James II, had been a mere 1.7 million pounds per year. While spending had grown four- or fivefold, revenue had not kept pace. Every conventional method — short-term borrowing, coin recoinage, tax increases — had hit a wall. Interest rates on short-term loans were soaring, the quality of silver coinage was deteriorating, and raising taxes further risked turning the populace against the Crown. Gold was draining away. Time was running out.
It was then that a Scottish merchant arrived with an idea.
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William Paterson.
In financial history, his name is recorded as the founder of the Bank of England, though strictly speaking, he was closer to its architect than its founder. And in an irony of history, he was ousted from the board of directors within a year of its establishment due to conflicts with fellow board members.
Paterson's idea was simple but revolutionary: change the guarantor of the nation's debt from the King to Parliament.
The specifics were as follows. Raise 1.2 million pounds from investors. Lend this money to the government in perpetuity — as a perpetual bond with no maturity date for principal repayment. In return, pay investors 8 percent annual interest. The interest payments would be guaranteed not by the King's promise but by an Act of Parliament. Parliament would pledge excise duties on alcohol and tonnage duties as collateral. Even if the King changed, as long as Parliament endured, the interest payments would continue.
And one more element was added. This group of investors would be granted a banking charter — the right to accept deposits, issue banknotes, and make loans. This was the Bank of England.
In April 1694, Parliament passed the Tonnage Act, authorizing the bank's establishment. In June, the investor subscription opened. And then something remarkable happened.
Within twelve days, the full 1.2 million pounds had been raised. The target amount was fully subscribed. The urgency of war likely spurred investment. The terms — 8 percent annual interest guaranteed by Act of Parliament — must have shone with particular allure in the memories of goldsmiths who had lost their entire fortunes to a king's caprice.
A total of 1,268 investors participated. They ranged from wealthy merchants to widows to country landowners. They queued at Mercers' Hall in Cheapside — the guildhall of the mercers, the textile merchants. The nation's future was being decided not in a royal palace but in a merchants' guild hall. Before the heavy wooden doors, merchants in silk coats mingled with widows in black wool as they waited their turn. A great leather ledger lay open on an oak table, and investors came forward one by one to inscribe their names and amounts. The quill pens of seventeen clerks moved without rest.
On July 27, 1694, William III pressed the Great Seal onto the Royal Charter. On August 1, the Bank of England opened for business at Mercers' Hall. Its staff consisted of seventeen clerks and two gatekeepers — nineteen people in total.
The first Governor to preside over these nineteen employees was Sir John Houblon. The Houblons were descendants of Huguenot refugees — French Protestants driven from Catholic France who had crossed the English Channel to find sanctuary. The grandson of those refugees had prospered as a merchant in the City of London, and now he was leading the financial institution of the very nation fighting against France. The descendants of people France had expelled were building the weapon that would defeat France. Houblon was one of London's foremost merchants, having amassed his fortune in the Levant trade, and his name had even been floated for the office of Lord Mayor. His appointment as Governor was not purely a matter of wealth or lineage. His refugee background sent a signal to investors: this man had no reason to compromise with France, and his motivation to win the war was stronger than anyone's. Three hundred years later, Britain placed Houblon's portrait on the fifty-pound note — a refugee's descendant, now the face of the nation's currency.
Beside Houblon stood the first Deputy Governor, Michael Godfrey, who had driven the practical work of establishing the bank. He designed the investor subscription process, set up the operational systems at Mercers' Hall, and created the procedures for approving the first loans. If Paterson drew the blueprint for the great machine called the Bank of England, it was Godfrey who actually assembled it.
Yet in 1695, the year after the bank's founding, Godfrey accompanied William III on a visit to the front lines in Flanders. His purpose was to personally verify the bank's credit on the battlefield — to see with his own eyes where the money the Bank of England had lent was being spent and how war expenditures were actually being disbursed. The Siege of Namur was underway. It was a front line where the thunder of artillery never ceased. The King warned him: do not venture beyond the trenches. Godfrey did not listen. While inspecting the front lines, a French cannonball struck. The first Deputy Governor was killed on the spot. It was barely a year after the Bank of England's founding. The man who had sat before the oak table at Mercers' Hall reviewing ledgers died in the muddy trenches of Flanders, killed by a cannonball. The man who had built the nation's financial system died on the nation's battlefield — a scene that reveals just how deeply intertwined war and finance were from the very moment this bank was born.
The two gatekeepers deserve a second glance. In the literal sense, they were doormen who guarded the entrance. But this bank was, from its inception, an institution of "gatekeeping." Whose money to accept, whom to lend to, whom to trust — those judgments were now entrusted to an institution rather than to individuals.
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What the Bank of England invented was not merely a bank. Three financial innovations were born simultaneously.
The first was the invention of the National Debt. Not the personal debts of a king, but the debts of a nation — guaranteed by Parliament and backed by tax revenue. Debts that remained valid even when the king changed. This was the transfer of the basis of credit from an individual to an institution. It stands in stark contrast to the Medici Bank, which depended on a single family as leadership passed from Giovanni to Cosimo, from Cosimo to Lorenzo. The credit of the Bank of England was not vested in any particular person. The system was designed to outlast the people who ran it.
The second was the perpetual bond. A bond that pays interest indefinitely, with no promise of when the principal will be repaid. Its genius was double-sided. From the government's perspective, war costs could be financed without the pressure of principal repayment. From the investor's perspective, the absence of a maturity date might seem to make recovering one's capital impossible — but one could simply sell the bond to someone else in the market. At the time, these bonds were bought and sold at Jonathan's Coffee House — a place with low ceilings, smoke-stained walls, and bewigged brokers climbing onto tables to shout their prices. Liquidity had been created: the ability to convert future interest income into present cash.
The third innovation — the most dangerous and yet the most powerful — was fractional reserve banking.
Here, let us pause to compare this with the finest banking system of the era: the Amsterdam Wisselbank. Founded in 1609, the Wisselbank adhered to the principle of full-reserve banking, keeping 100 percent of deposits in its vaults. Deposit 100 in gold, and 100 in gold sits in the vault. Safe. But the bank's capacity was limited. The gold piled in the vault simply slept there, producing nothing. It was a system that was secure but impotent. Under the Wisselbank's principles, the only ways to fund a war were to raise taxes or discover a gold mine.
The Bank of England did things differently. It issued more banknotes than it held in deposits. If 100 in gold sat in the vault, the bank printed 150 in banknotes and lent 50 of them to the government. It had created money out of nothing. Paterson understood this precisely. There is a famous remark attributed to him by later generations: "The bank hath benefit of interest on all moneys which it creates out of nothing." However, the original wording cannot be verified in any of Paterson's known writings. Although the phrase has been repeatedly cited in financial history, no confirmable primary source exists — it is an attributed quotation. The accuracy of the wording is uncertain, but few sentences have ever summarized the operating principle of the Bank of England more precisely.
So what physical form did this "money created out of nothing" actually take? When the first withdrawal request came in at the counter of Mercers' Hall, what the clerk handed over was not a printed bill. On a rectangular piece of paper, a clerk wrote the amount by hand with a quill pen — for instance, "53 pounds 10 shillings 6 pence." Below that appeared the phrase "I Promise to pay the Bearer on Demand..." along with a bank official's signature. This was the earliest banknote. Strictly speaking, it was closer to a deposit receipt than to currency, and the amounts were not standardized — each depositor received a note with a different figure written on it. These scraps of paper, born from the handwriting of seventeen clerks, began to circulate in the London market. A merchant accepted the paper and handed over goods. Another merchant accepted that same paper and used it to pay for a ship's cargo. The promise written on the paper passed from hand to hand, mediating real transactions. More promises were written on paper and circulating in the market than there was actual gold in the vault. Where the Amsterdam Wisselbank depended on the weight of the gold in its vaults, the Bank of England depended on trust in a clerk's signature. Fractional reserve banking was, in the end, this: the moment when trust replaced gold. This system works as long as people do not all rush to the vault at once to demand their gold. And what happens when that "everyone rushing at once" scenario actually occurs — that, we shall witness later in this chapter.
This magic — or this near-fraudulent magic — is what enabled England to prevail over France in war. France had three times the population and three times the economic output. But France's finances came from the king's treasury, while England's came from a credit system. England did not win because it had more money. It won because it had a better system — the ability to pull future tax revenues forward and spend them on the present war.
In November 1696, the Bank of England drew up its first balance sheet. Total assets: 3.3 million pounds — nearly three times the 1.2 million pounds that investors had originally contributed. In just two years, the leverage of fractional reserve banking was already at work.
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But the magic of creating money out of nothing comes at a price.
The system that the Bank of England had built was powered by a new engine called national credit. What happens when that engine is fueled by private greed was demonstrated twenty-six years later.
In 1711, the South Sea Company was established. Its creation was spearheaded by the Tory politician Robert Harley. Since the Bank of England was the financial backbone of the Whig party, the Tories needed their own financial instrument. Political rivalry had spawned the imitation of financial innovation.
The stated purpose was a monopoly on trade with Spanish South America. In reality, the Company was a vehicle for absorbing the government's toxic debt. Having observed how the Bank of England used national debt as the foundation for credit creation, the South Sea Company replicated the same structure — acquiring government bonds in exchange for the right to issue shares.
But there was a critical difference. The Bank of England's revenue model was interest income and banking — revenue connected to the real economy. The South Sea Company's revenue model was the rising share price itself. The Company offered holders of government bonds a proposition: "Exchange your bonds for our shares." Since a higher share price meant that fewer shares were needed to retire more debt, inflating the stock price became the Company's overriding imperative. It was a system driven not by earnings but by expectations. Actual revenue from South American trade was negligible. Spain permitted English merchants only one trading ship per year, and even then, a substantial portion of the profits had to be remitted to the Spanish Crown. The Company's books showed virtually no trade income. The South Sea Company was "South Sea" in name only — it had never made money from the sea.
In 1720, London began to lose its mind.
South Sea Company shares, which had stood at 128 pounds in January, hit 1,050 pounds by June. An eightfold increase. In Exchange Alley — a narrow, mud-caked lane in the City — aristocrats, merchants, and maidservants jostled together buying and selling shares. In an alley too narrow for carriages, bewigged brokers stood on tables bellowing prices. Beneath the low ceilings of Jonathan's Coffee House, amid the scent of coffee and chocolate, rumors were manufactured and consumed. "A ship loaded with gold is on its way from Spain." A baseless rumor was enough to make the crowd erupt in cheers.
South Sea Company shares were not the only thing surging. The frenzy conjured phantom companies into existence. Without parliamentary authorization, without any substance, enterprises that were nothing more than a name sprang up across London to sell stock. "A company for building a perpetual motion machine." "A company for raising silver from the bottom of the Atlantic." There was even one selling shares under the prospectus: "A company for carrying on an undertaking of great advantage, but nobody to know what it is." People queued up and handed over money to a company that had declared it would not disclose what its business was. Promoters with absurd business plans attracted swarms of investors. Money poured into these bubble companies, and from the South Sea Company's perspective, this was a threat. Capital that should have been flowing to its own shares was leaking away to competitors.
In June 1720, the South Sea Company reached out to Parliament. The result was the Bubble Act — legislation prohibiting the formation of joint-stock companies or the issuance of shares without parliamentary authorization. On the surface, it looked like sound regulation designed to protect investors. The reality was different. The South Sea Company's directors had lobbied Parliament to cut off the air supply to their competitors. It was a calculated move to funnel the market's money exclusively into their own company.
The law passed, and the phantom companies were forcibly dissolved. Companies operating without a Royal Charter received dissolution orders, and trading in their shares was immediately banned. But something unexpected happened. Investors who rushed to sell their phantom-company holdings and convert them to cash did not redirect that money into the South Sea Company. Liquidity across the entire market began to seize up. Sellers flooded in while buyers vanished. The South Sea Company had been caught in its own trap. The law it had created to kill its competitors was suffocating the entire market and pulling its own share price down with it.
By this point, the insiders were already making their moves. John Blunt, the South Sea Company's chief architect, along with several directors, had begun quietly offloading their shares onto the market starting in June. While publicly proclaiming that "the share price will go higher still," they were selling their own holdings. The gatekeepers had left the door open and slipped out first.
The five stages of a bubble that Charles Kindleberger would systematize two centuries later — Displacement, Boom, Euphoria, Profit-taking, and Panic — played out in perfect sequence in 1720 London.
And at the very center of this bubble stood one man. One of the greatest intellects in the history of the human race. The man who discovered the law of universal gravitation, who co-invented calculus, who laid the foundations of optics. Isaac Newton.
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The Newton of 1720 was the Master of the Mint — the official who oversaw England's monetary system. To this genius who had codified the laws of the universe in mathematics, the stock market must have seemed as straightforward as the law of gravity.
In April, Newton sold his South Sea Company shares at around 300 pounds per share, realizing a capital gain of roughly 7,000 pounds — approximately $1 million in today's terms.
It was a clearheaded decision. He had detected that the share price was overheated, locked in his profit, and exited the market. Worthy of a genius.
But after Newton left the market, the market did not stop.
May: 500 pounds. June: 700 pounds. When Newton had sold at 300, the people around him were laughing and buying. Friends who knew nothing of mathematics or economics were becoming overnight millionaires. At meetings of the Royal Society, while riding his carriage through London, everywhere he turned, the same story reached his ears. Yesterday 500, today 600, tomorrow 700.
His 7,000-pound profit suddenly looked meager. If he hadn't sold, it would have been 14,000. No — 20,000. Newton was an official at the Mint who spent his days tracking counterfeiters and assembling evidence with methodical logic. Judgment grounded in data was his profession. And yet this man was swept up by the mood around him and reversed his own call. What Kahneman would later term "System 1" — the fast, emotional intuition — overpowered the slow, calculating rationality.
In late June or July, Newton re-entered the market. He poured nearly his entire fortune — 20,000 pounds — into South Sea Company shares at between 700 and 800 pounds per share. In July, the price approached 950 pounds, hurtling toward its peak. The stock that had opened the year at 128 pounds had more than septupled in six months.
But what was actually happening at this point? Immediately after the Bubble Act passed, the South Sea Company's directors and Blunt's inner circle had already been unloading their shares onto the market. The people who knew what was really going on inside the Company were getting out, and people like Newton — returning from the outside — were filling the seats they had vacated. Smart money was exiting; emotional money was entering. Newton's re-entry occurred at the precise crossover point. It was the moment a once-rational genius became a member of the irrational crowd.
The party did not last long. In August, the share price began to waver, and by September it was in freefall. When the price dropped below 400 pounds in September, the Sword Blade Bank — the South Sea Company's de facto clearing bank — suspended payments. A chain reaction began. Investors who had borrowed against their South Sea shares as collateral could not meet margin calls. Banks force-sold shares to recover their loans, and those forced sales dragged the price down further. By December, the share price stood at 124 pounds. It had returned to roughly the price at which Newton had first made his 7,000-pound gain. The starting point in January was now, for Newton, the endpoint. He was left with nothing. Twenty thousand pounds had vanished. Considering that an ordinary laborer's annual wage at the time was a few dozen pounds, it was a sum equivalent to several hundred years' wages.
After the bubble burst, Newton is said to have forbidden anyone from uttering the words "South Sea" in his presence for the rest of his life. And then there is the famous line passed down through the generations:
"I can calculate the motion of heavenly bodies, but not the madness of people."
This sentence first appeared in Anecdotes, Observations and Characters of Books and Men by Joseph Spence, published posthumously in 1820, and does not appear in any of Newton's own writings. The precise wording may have been polished by later generations. But Newton's lifelong and intense aversion to any mention of the South Sea Company is confirmed across multiple historical sources. The accuracy of the words may be uncertain, but the authenticity of the emotion behind them is beyond doubt.
Even the genius who discovered the law of universal gravitation was not immune to the emotional gravity of FOMO. Newton conquered the laws of the physical world with mathematics, but before the psychological laws that operate within a crowd, he was powerless. That is the South Sea Bubble's most enduring lesson: The capacity for folly has nothing to do with IQ.
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The South Sea Bubble was not merely a speculative episode. It was the first systemic failure of the gatekeeper system.
The very people who should have been overseeing the market were instead the agents of speculation. King George I served as the Company's Governor. Chancellor of the Exchequer John Aislabie received free shares from the South Sea Company, and dozens of members of Parliament were co-opted in the same fashion. The bribe of free shares cut a path through Parliament, greasing the passage of the Bubble Act itself. The people who should have been designing regulations were receiving compensation from the entity they were supposed to regulate. The gatekeepers, instead of closing the gate, had flung it wide open.
After the bubble burst, Parliament formed a Secret Committee of inquiry. The books were opened, and the trail of bribes was revealed. John Blunt, the South Sea Company's chief architect, had approximately 178,000 of his roughly 183,000 pounds in assets confiscated, leaving him with a bare 5,000 pounds for subsistence — 97 percent of his fortune, gone. Chancellor Aislabie was imprisoned in the Tower of London. But the most significant outcome was not the punishment of individuals — it was structural change.
During the crisis cleanup, the Bank of England absorbed a portion of the South Sea Company's toxic debt, displaying an early form of the "Lender of Last Resort" function. The South Sea Company had sought to replace the Bank of England; through its failure, it instead cemented the Bank of England's standing.
Herein lies a crucial structural contrast.
The Bank of England and the South Sea Company both originated from the same financial innovation: converting national debt into private capital. The mechanism was identical. But the Bank of England's revenue model was interest income and banking — connected to the real economy — while the South Sea Company's revenue model was the appreciation of its own share price. One has endured for more than three centuries. The other collapsed within a decade.
The same tool produced entirely different outcomes. The difference lay not in the tool but in the operating structure. The Bank of England accepted deposits, issued banknotes, and made loans to the government and merchants, earning interest in the process. Its credit creation was tethered to real transactions in the real economy. The South Sea Company's directors, by contrast, cared about only one number: the share price. Neither trade revenues nor interest income — the market's expectations themselves were the asset. The Bank of England served as a gatekeeper connecting credit creation to the real economy; the South Sea Company became a case where the gatekeeper itself was turned into an instrument of speculation. The pattern that Portinari of the Medici Bank had demonstrated in Chapter 1 — the corruption of the gatekeeper — repeated itself twenty-six years later, on a vastly greater scale.
7
The Bank of England survived.
When it was first established, the institution bore little resemblance to a modern central bank. It was the government's bank and a monopolistic joint-stock company, but it did not supervise other banks or execute monetary policy. Yet through the crisis management of the South Sea Bubble, through subsequent financial crises, and alongside the expansion of the British Empire, the Bank of England gradually acquired the role of a central bank. In 1734, the bank moved to a new building on Threadneedle Street. From a temporary tenant at Mercers' Hall, it had become a permanent institution with a building of its own. Londoners came to call this building "The Old Lady of Threadneedle Street." Institutions grow by feeding on crises.
The structure that the Bank of England created — national debt, central banking, financial regulation — has spread across the entire world over the past 330 years. The BIS (Bank for International Settlements), the Basel standards, capital adequacy ratios — the rules that every bank in the world follows today have their roots in Mercers' Hall, London, 1694. If the Medici Bank created the prototype of personal credit, the Bank of England created the prototype of institutional credit.
And yet something gives pause.
The institutions have grown more sophisticated over 330 years. From national debt to central banking, from central banking to dedicated financial supervisory authorities, from supervisory authorities to BIS ratios and Basel regulations. The system has been built up layer upon layer, growing ever more complex. But the very last moment at which capital allocation is actually decided — the moment when someone sits at a conference table, turns the pages of a document, and judges "Can we lend this money?" — that moment bears a striking resemblance to the scrittoio of the Medici.
Between the Florentine banker signing a bill of exchange on a sheet of parchment and five people in a tenth-floor conference room of a savings bank on the outskirts of Seoul deliberating over a 68-billion-won (approximately $50 million) project finance loan, there lie six hundred years and the distance of continents. And yet at their core sits the same question:
Can this person repay the money?
The tools have evolved, but the agent of judgment is still human. And human judgment — as Newton proved — has its limits, even in a genius.