Saturday, 25 February 2012

Bubble: the Burst

At the most extreme point of trade, buyers started to question whether the growing prices could be maintained, and, to doubt if the supply of bulbs will not be increased devaluing their investment. Buyers refused to pay any higher prices spreading the panic across the country, which destroyed the market within days – the market for tulips collapsed. This domino effect resulted in demand for bulbs almost disappearing, hence reducing the price to a hundredth part of the previous amount.

* Property (mortgage) crises led to a number of banks being nationalised, such as, in 2008, the UK government nationalised Northern Rock. News led to a bank run, which have been caused by BBC journalists’ announcing it on their blogs. Panicked customers rushed to withdraw their savings with a fear that a bank can become insolvent, it increasing the likelihood of default even more. When Northern Rock was nationalised, the British government paid out all deposits held by it.

The uncertainty hit the market after the crash: bulbs that were bought and sold on paper, lost their value while still in the ground, so buyers were expected to default on their promise. Failure to come up with an agreement to set up a fine, which would allow the purchases being nullified, led the high court decision that all contracts are in force, and both parties must resolve any issues themselves (referring to court only as a last resort). However, government intervention was necessary to create a commission, which set up a fee payable (it was only a small part of a trader’s liability) in case of transaction cancelation, to balance out the damage between the seller and the buyer. Posthumus (1929) indicates that the Dutch government commanded to interpret all the contracts that were written after November 1636, and before March 1637 as option contracts.

The tulip mania affected a fraction of a population, since the ones speculating in the market were from the wealthiest class of society, and losses were notional, as trade occurred only on paper, unless one of the parties credited their purchases with expected profits.

After the crash, the risk shifted from the seller, who could have previously fail to deliver a quality bulb, towards the buyer, who now was more likely to default refusing to complete the purchase. You can read a more detailed story here.

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