…and yet another argument to support Garber

Another research by E. A. Thompson (2006), “Tulipmania: the fact or artifact”, supports the notion that the tulipmania is not a bubble. He argued: “bubbles require the existence of mutually-agreed-upon prices that exceed fundamental values”. Thompson (2006) described the episode simply as “the period during which the prices in future contracts have been legally, albeit temporarily, converted into options exercise prices”. E. A. Thompson (2006) research follows P. M. Garber's (1990) work, and achieves to demonstrate that the more accurate data set allows the comparison of the price decline in a various bulb markets (i.e. he specifically looked at the hyacinth price dynamics).

Thompson (2006) indicates that the increase in tulip bulb prices may have been caused by the “Thirty - Year’s War”. He also explains that the main mistake, which must have led to the tulip market crash, was the arrangement of contracts. In 1636 Autumn contracts reflected the expectation rather than real values, hence “contract price being a call-option exercise”, or strike (set at around 10 times the actual prices), “rather than a price committed to be paid for future bulbs”. Option holders were not bind to pay the contract price if the spot price appeared to fall below the contract price, hence they would only have to pay a small compensation fee in a case of cancelled contract.

Informed traders managed to liquidate their contracts escaping the crash, whilst uninformed, ‘noise’ traders, did not possess any valuable market information which would have saved them from bankruptcy.

Thompson (2006) disagreed with Mackay’s (1841) view of tulipmania as “a delusion and madness of crowds”, on the other hand, he proved that a market was fully functioning, with contract prices adjusting to an economic environment. In Thompson (2006) opinion, the tulip market crash was initiated purely by the fact that there has been a shift from future contracts to options. An article on his research can be accessed here.

Empirical Research: not a bubble at all!

Views of many economists differ/cross as of how to precisely define the phenomenon of a sudden price rise and fall of tulips in the 17^th century Netherlands. It is necessary to demonstrate varying definitions of the tulipmania.

Famous economist, P. M. Garber (1990), an expert in the field, describes tulipmania as an “outbursts of irrationality”, while G. A. Calvo, in The New Palgrave (1987), refers to the tulipmania “as a situation in which asset prices do not behave in ways explained by economic fundamentals”. An American economist P. A. Samuelson (1967) argued that the occurrence of such events do not necessarily impact real markets, and defines the tulipmania as “the purely financial dream world of indefinite group self-fulfillment”, whereas Shell and Stiglitz (1967) saw the tulipmania as a speculative boom.

In his research Garber (1984) considered the possibility of tulipmania due to the fact that, in 1634, the market of bulbs was increasingly filling up by unprofessional traders. Garber (1984) came to the conclusion that there were not enough data to make a solid argument, whether bubbles exist, or inflated prices are just a consequence of the crowd madness. He stated that limited, but a growing supply of some luxury good would reflect the same price change pattern as tulip bulbs.

P. M. Garber continued the research, and in his article, “First Famous Bubbles” (1990), argued that the collapse of the tulip market may have led to the economic instability in the Netherlands. He disagreed to qualify the tulipmania as a bubble; his arguments were:

-       By analysing a famous research conducted by Mackay (1852), Garber (1990) discovered misleading information: the data adopted by Mackay was incorrect (he used prices of bulbs 60-200 years after the collision of the market, which did not reflect the true picture). Moreover, he failed to conclude that price fluctuations of rare bulbs were typical to any market of rare varieties.

-        In his research, Garber (1990) succeeded to account few price depreciation rates: during the mania, after the crash and the 18^th century bulb market. By comparing it, he concluded that price fluctuations were not as sharp as it was stressed out.

-        It is frequently cited that the collapse of the tulip market significantly distressed the Dutch economy. Garber (1990) argued that there are no reliable historical sources to fully support the argument. Moreover, the period is often treated “as a golden age in Dutch development”.

A full article on Garber’s research can be accessed here.

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.

Bubble: development of the Bubble

With dramatically rising demand, tulips became a stock of mass production and bulblets were sold while still in the ground, half a year prior to its lifting. This developed a futures market. The deception increased even further in the market, speculators bought tulip bulbs hoping that after lifting the value would have increased allowing them to re-sell it to other buyers, thus generating a profit. The market became very opaque: sellers did not know what they were selling, buyers-what they were buying.

In 1636, November – December, the trade in tulip bulb futures reached the peak of absurd - prices tripled (very popular breed prices went up 10 times), even previously despised plain tulips were sold, bulbs no longer were sold by its weight, but could be purchased in a dozen, pounds or baskets. Greedy Dutch deposited everything they had to pay off the purchase: from clothes and cows, to land and houses. The market became entirely speculative: it no longer involved exchange of goods, instead paper contracts and promises – buyers held no cash to finance their purchase, sellers held no actual bulbs. The uncertain ownership of tulips shifted amongst speculators while bulbs were still in the land.

This situation is similar to a real estate bubble of 2005, when at its peak people stopped thinking and took out levels of debt that they could not afford to pay back, and all only to project their “wealth”. Borrowers started taking out loans, promising to pay it off with expected future earnings, in order to purchase something they cannot afford. Banks gave out loans to high risk borrowers, despite the fact the reserves they held were not large enough to finance it, and so banks needed to borrow from other banks. It later led to a ‘credit crunch’, a number of banks failing in 2007-2008.

Bubble: the Boom

Economic bubbles tend to have three stages: from its formation to its crash. It starts off with a boom, grows into a bubble, and bursts at its peak crashing the entire market. In order to demonstrate how tulip mania conveys these characteristics I have to start at the beginning explaining the process in a bit of detail.

 

Tulips were sold in bulbs. The process would take a while, as it was planted in September, bloomed in May, and lifted from the ground in June. The bulbs were examined and kept dry indoors. There must have been high levels of trust between the buyer and the seller, since tulips may not have blossom (which was considered one of the major attractions and was the main argument for purchasing it) same as years before, hence increasing the fraud in the market.

The price of the bulb depended on its weight (measured in aasen=0.0017ounce) which was seen as a good way to calculate prices - immature bulbs priced less, and mature bulbs being more expensive.

The sudden increase in the prices of tulips, in 1635, shaken the market and resulted in bulbs being sold while still in the ground. A buyer and a seller would make a paper premise to agree on the price (usually measured by the weight before planting it). However, this encouraged speculation (and moral hazard) between the two parties: the value of the bulb may increase significantly during the nine - month period it is in the ground, because of its growing weight, hence heavier bulbs tend to have more “bulblets”(planting a bulblet reduced the time of maturity needed to flower by almost a half, compared to growing it from seed). To maintain a short supply of particular bulbs sellers kept some rare kinds from trading. Traders encountered losses by so called “broken” bulbs (affected by disease which would not produce bulblets or would not flower), and bulbs, which were eaten mistakenly instead of onions.

Another boost in prices of tulips was caused by an increased variety of it (vivid coloured and symmetrically marked). Enchanted Dutch went crazy for bulbs which were changing its colour over seasons; the mystery cause of such a miracle was discovered in the 20^th century being a virus transmitted by aphids.

At its peak the price of the bulb reached insane values, the most popular and rare bulbs of “Semper Augustus” and “Violetten Admirael van Enkhuizen” being sold at over 5000fl (the Dutch currency at a time ‘guilder’). It is difficult to transmute in todays' value, but if looking at the Dutch monetary values at a time, 1000fl would buy a small house in Haarlem, 100 hogshead of wine, over 25,000 pounds of rye bread, etc; whilst, a carpenter earned annually 250fl, a wealthy merchant over 1,500.

It means, a single tulip bulb was selling for over 20 times the average Dutch annual income. So, say average annual income in the UK is around £32,000, then a single bulb would cost you £700,000, would you buy it? This situation can be best described quoting Oscar Wilde – “A man knows the price of everything and the value of nothing”.

The bewitched Dutch

The cause of the tulip mania, is not only considered as a consequence of peoples' foolishness to believe such a delicate and luxurious commodity (which only flowers two weeks a year) would produce an ever growing market, but also fallen quantities of tulips demanded by Germans (caused by the Swedish success in 1636 in the Thirty - Year War), as well as the pestilence in the Netherlands during 1633-1637, which dramatically reduced the population and increased a shortage of labour force resulting in higher wages, therefore allowing people to invest in tulips.

It is not known precisely when first tulips were brought to Europe, according to some historical sources they were first mentioned in the mid 16^th century. Despite this fact, the Dutch became “crazy” over tulips only in the early 17^th century, almost a century later. People believed tulip represented their wealth so liquidated their assets to purchase bulbs, thus were willing to trade food, goods and wealth for a dull flower, all to project their economic status.

Mark Frankel in Bloomberg Businessweek wrote that “the Dutch population seemed torn by two contradictory impulses: a horror of living beyond one's means and the love of a long shot”, you can read the full article here.

Jan Brueghel, the Younger, “A Satire on the Folly of Tulip Mania” painted in 1640 to represent the absurd of the Dutch portraying them as brainless monkeys.  The detailed interpretation of the painting which depicts the course of the trade specifically can be found here. I have dedicated next three blogs to explain the way in which the tulipmania occurred.

Introductory insights

Financial markets not always function in harmony; certain events may disturb the stability leading to contractions in a financial system. The inefficient functioning of the market is a result of increased moral hazard and adverse selection problems. A rise in interest rates or uncertainty, bank panics, or sharp changes in the asset market, affecting balance sheets, are considered to be the main factors generating financial crises. Financial crises can take a form of crash (ex. the stock market), a bubble (also referred as mania or balloon), panics, currency or banking crisis, recession or depression.

Mishkin and Eakins (2006) define a bubble as “a situation in which the price of an asset differs from its fundamental market value”, i.e. when assets (or products) are traded at inflated prices. However, some economists disagree that bubbles occur, and thus argue it is negligible to induce financial crises.

The long history of bubbles date back tracing the very first bubble in: the 17^th century Holland’s Tulip Mania (of 1630s); the 18^th century - the South Sea bubble and Mississippi bubble (1720); the 19^th century - Railway Mania (of 1840s); the 20^th century - the Stock Market bubble (Wall St. Crash (1929), the Great Depression (1930s)), the Dot-com bubble (1990s); up to the most recent ones, the 21^st century - Housing bubble (burst in 2005) and ‘Credit Crunch’ (2007/08).

The Dutch tulip bubble is, for most economists, a starting point in search of inefficient market behaviour (bubbles, instability, etc.) and a fundamental definition of the financial bubble. In my blog I am going to explore tulipmania in greater detail. I will research the topic area and try to define whether the tulipmania was a bubble or only the consequence of irrational behaviour.