Many folks appear to be convinced that the current housing situation is akin to any of a
number of other famous financial bubbles of history. Trouble is, those famous bubbles weren’t
very much like what most people seem to assume.
If you talk long enough with someone who’s persuaded that today’s housing market is
experiencing a bubble, the topic eventually is likely to turn to alleged precedents like the
Dutch tulip mania.
Calculated Risk, the Motley Fool and Seeing the Forest
are among those whose fancy this past week turned to thoughts of those old Dutch tulips.
Much of the popular understanding of the Dutch tulip mania is derived from Charles Mackay’s
delightfully written book, Extraordinary Popular Delusions and the Madness of Crowds ,
whose first edition appeared in 1841. Nine colorfully narrated pages describe the market for
tulips in Holland between 1634 and 1637.
It was not until 1989, however,
that the record of this episode was really set straight by the careful research of Peter Garber
published in the Journal of Political Economy. Garber documented that the spectacular
tulip prices recounted by Mackay never applied to ordinary tulip bulbs, whose prices, even at
the height of the frenzy, were quoted like produce by the half-pound or pound. The
extraordinary prices characterized instead a few special lines of tulips that had been infected
by a mosaic virus which in some circumstances produced a particular pattern judged to be
beautiful, such as the Semper Augustus shown at the right. But if you liked the effect in a
particular flower, the only way to reproduce it would be to cultivate a few buds from the
original, hoping to have two or three bulbs in the following year with the same qualities.
Unlike the modern notion of a bubble as an asset for which market participants believe the
price will continue to rise, Garber claimed that tulip cultivators always understood that the
price would eventually fall. As long the price falls by less than 50% each year, if the grower
was successfully able to cultivate 2 or 3 new bulbs from the original, he would come out ahead,
because paying 100 guilder for 1 bulb and next year selling 3 bulbs for 50 guilder each is a
winning proposition. In a rational market, the value of the original bulb should equal the
discounted present value of the future net proceeds after cultivation costs of the bulbs that
could be uniquely produced from the original. Given a market for flowers that values unusually
beautiful flowers at a higher price, such a valuation implies that the initial price could be
quite high but quickly fall over time as more bulbs like it become available each year. There
could be (and was) an initial period in which the price actually rises, and quickly, as growers
discover that this particular kind of flower is the one everybody would like to have. But from
there the rational equilibrium is one where everybody understands that the price will fall
rather rapidly, and knowledge of this reality does not discourage a buyer from paying the
initial high price.
And this is precisely the pattern that Garber found, both through the alleged mania and for
the centuries afterward for which more thorough data can be assembled. Garber could find no
indication that anyone experienced financial distress as a consequence of the decline in prices
of some of the fanciest mosaics in 1637, or that the rate of price decline between 1637 and 1642
was significantly different from that seen for other special lines of tulips or hyacinths
developed in the 18th and 19th centuries.
It is true that there evolved in certain Dutch taverns a system for buying and selling the
year-ahead crop for more common bulbs in which more ordinary people participated for more
ordinary sums, in part emulating what they saw going on with the rare bulbs market and hoping to
profit on a more modest scale from the popularity of the flower more generally. The brokers of
such deals were paid with what was described as “wine money,” and such agreements were legally
stipulated to be nonbinding for the 1637 harvest. Garber concluded that, if there was anything
to the idea of a “bubble” in the tulip markets of this time, it applied to these small-time
tavern-negotiated agreements. But Mackay’s account would have been far less entertaining had he
simply reported the details of these rather modest deals.
And if your next question is, “but what about the Mississippi Scheme or the South-Sea Bubble,”
I invite you to take a look at Garber’s examination of these in his paper published in the
Journal of Economic Perspectives in 1990.
I do, by the way, agree with Mackay’s principal thesis that our species is prone to
believing in something that isn’t true just because we see that those around us seem to accept
its veracity. I’m just wondering whether the conviction that there was such a thing as a Dutch
tulip mania might not itself be an example of such a popular delusion.