Today in our regular series on lessons from financial history (we've recently looked at Overend Gurney, and the panic of 1907) I want to talk about the closest thing we have to a mythical bubble.
It's the one that everyone's heard about. More so even than the South Sea bubble or the Great Depression or dotcoms, it's the "go-to" comparison for anything that looks remotely like a feeding frenzy in the markets.
We're talking, of course, about tulip mania...
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Journalists exaggerating? Shurely shome mishtake
Tulip mania is a legendary bubble, and I mean that quite literally. No one disputes that the South Sea bubble happened, or that the Great Depression was real. But uncovering the reality behind the tulip bubble is quite a bit trickier.
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The basic story is that tulips were beautiful and rare. Merchants in Amsterdam snapped them up as luxury items. Prices soared from roughly the early 1630s, peaked in 1637, and then crashed. People lost fortunes in the process, having traded houses for tulip bulbs, and all the rest of it. A classic mania, in other words.
Charles Mackay tells the story wonderfully in his Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. But as you read more background on the story, it seems fair to say that Mackay might have egged the pudding a bit in order to tell a better story (so it turns out that they had "fake news" all the way back in 1841 not that I'm one to criticise a fellow Scottish journalist for indulging in a bit of poetic licence).
At the same time, all the "hot takes" you read, claiming that there was no tulip bubble at all, seem to be exaggerating too. The headlines on these pieces claim to debunk the idea that there was a tulip mania, but when you read the actual stories, they're really only arguing that while tulip prices did surge then crash, it didn't cause a huge recession. In other words, the bubble wasn't as epic as its legend suggests.
That's a fair point but it's also not that groundbreaking. Few people argue that tulip mania was up there with the financial crisis in terms of its fallout. But as a beautiful example of how people can ascribe ludicrous valuations to just about anything, it takes some beating.
While researching this piece, I read a very good paper from 2012 on the topic: The Dutch Tulip Mania: The Social Foundations of a Financial Bubbleby A. Maurits van der Even, at Virginia's College of William & Mary. I've drawn most of my understanding of what went on from that piece. So here goes.
What really happened during tulip mania?
Tulips came to Western Europe from Turkey in the 16th century. They were popular from day one, pretty much, and wealthy collectors were always willing to pay a premium for the best ones. As van der Even notes, a book published in 1614 well before the bubble phase started displays a tulip alongside the proverb "a fool and his money are soon parted."
One reason that prices were relatively high is because no one knew exactly how to breed popular strains consistently, and supplies of the most popular bulbs were limited often controlled entirely by one breeder.
So there was always a healthy market for attractive tulips. But usually, the tulips were bought and sold while in bloom. By the 1630s though, sales were happening all year round, which meant that people were buying bulbs without necessarily knowing how the flowers would turn out.
And then a futures market developed. "People began to sell bulbs for which they had signed a contract but which they did not yet have in their possession." In effect, you could spread bet on the price of tulip bulbs taking a punt on the price without owning the underlying asset. "Not surprisingly," says van der Even, "it took little time for speculators to enter the market."
At the time, Amsterdam was thriving and the middle class was growing, so there was plenty of money flying around. Also, the tulip market was relatively deregulated no guild controlled the trade. So it was easy for interested parties to get involved.
As the excitement grew, access was made ever easier. Eventually, by the end of 1636, it was possible to trade generalised (rather than specific) bulbs in bulk contracts. That meant anyone could speculate, almost regardless of what they actually understood of tulips.
This, says van der Even, appears to have set off the real bubble phase, which lasted for about three months. Between December 1636 and February 1637, "some individual bulbs were sold as many as five to ten times, and increased more than tenfold in price." Demand even for unremarkable bulbs soared.
And then, prices simply collapsed. Van der Even argues that, in effect, it became clear quickly that the rapid increase in the price of the bulbs the ordinary ones in particular was unsustainable. Equally, even at the peak of the boom, the network of buyers and sellers was small, so once one bulb auction failed, the news spread fast.
Those who had agreed contracts to buy tulips in the future either ripped them up or paid a fraction of the value. Records show that one cancelled contract was bought out for around 10% of the agreed price, for example.
Mackay's claim that "the commerce of the country suffered a severe shock" is untrue, it seems. The bursting of the tulip bubble had little impact on the Dutch economy and most of the tulip buyers were well off and had at worst, lost paper profits.
Far more consequential was the plague that swept Holland in the early 1630s. For example, house prices along the Herengracht canal fell by nearly 50% between 1632 and 1634, and roughly 14% of Amsterdam's population died in 1636 alone. But none of that had much to do with tulip mania, except perhaps to add to the general feverish sense of the times.
Tulips were all about trust
So what can tulip mania really tell us? Perhaps the most interesting aspect is what it says about the role of trust and technology in the financial system.
In 1720, Dutch writers and artists were comparing the South Sea Bubble and the resulting international financial crisis to tulip mania. Futures contracts were depicted as tools of the devil. So while tulip mania might not have had a huge economic impact, it certainly left its mark on the collective memory.
Obviously, there was a moralistic element to all of this (unsurprising, given the times). Some people in the tulip trade at the time were angered that the "real" value of the flowers was being corrupted by the financialisation of the market. People who had no love or respect for flowers were treating them like commodities.
If you're trying to wrap your head around this, then as a modern day analogy, just think about how a struggling first-time buyer might feel about a serial house-flipper.
This notion that money can sometimes divorce itself from the "real" utility of an object, and do so in a way that devalues both the object and those who want or need that object is hard to pin down, but it's important, I think.
Trust is the glue that binds us together as a society. Money serves as something of a substitute for trust. It enables people who don't know each other very well to do business together.
But when you start playing around with the value of money, or you introduce more complex forms of finance which always means added borrowing into the equation, or when money itself appears to be the end goal, rather than a tool for easing the process of exchange, then you start to erode that trust.
I'm still firmly of the belief that the fallout from 2008 isn't so much about inequality or the "left-behinds" (though I'm not denying that's part of it) as it is about the shaking of our collective faith in the financial system. It's hard to exaggerate how dangerous it is to allow that trust to be undermined.
(Indeed, one of the biggest populist uprisings in the US which happened in the 1890s was largely about changes to the monetary system. We'll cover that particular boom and bust period later on in this series.)
This is not to say that financial innovation is a bad thing per se. But when it's taken to its extremes and it always is the fallout leaves people feeling disorientated, rudderless and angry. Particularly if they feel they've been ripped off in the process, which the finance industry has the unfortunate habit of doing with monotonous regularity.
If you don't have faith in the integrity of the system in which you operate, then your propensity to take risks your "animal spirits", as Keynes might have put it will be horribly suppressed. And no amount of slashing interest rates can rectify that psychological damage.
In short, tulip mania tells us a lot about people. And that's why it's endured as the bubble archetype, even if its consequences were a lot less brutal than those of many of its successors.
