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Calm Down Economic Bubbles Are Nothing New





Lost in all of the media frenzy surrounding Wall Street, the meltdown and the sub-prime lending debacle are certain lessons from history that can offer some useful perspective and even have a calming effect. Economic bubbles are nothing new, and contrary to what the media might have you think, they dont signal the end of Western Civilization, either.

In his book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay wrote, Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

That fact is as true today as it was when originally penned in 1841. Even then, speculative market bubbles had come and gone. One of the most curious spread through Holland some 200 years earlier, in the early 17th century. It was a financial epidemic thats come to be known as Tulipmania.

When Carolus Clusius planted that first tulip bulb in the Botanical Garden in the Netherlands in 1593, no one could have predicted the absurd financial maelstrom that would eventually culminate in the Great Commodity Crash of 1637. By 1620, tulips had become a status symbol in the wealthiest of circles.

About that time word spread among high society that a mysterious plant virus had infected some of the bulbs. But rather than spelling the imminent demise of the tulip, the virus actually created unusual and beautiful streaks of vibrant color throughout the petals, making the new varieties even more coveted. The rich and famous always clamor for the rare and exclusive, so the prices for all tulip bulb varieties shot sky high. Greedy speculators came from far and wide looking to make a profit; the stage was set for a thundering herd approaching on the horizon.

There was so much excitement that tulip bulbs began trading on the local market exchanges, which operated much like modern-day commodity exchanges. Soon, the fever spread to the Dutch middle class, and everyone from noblemen to chimney sweeps was jumping on the tulip bulb bandwagon. They hadnt suddenly developed green thumbs or a desire to take up floral arranging far from it. They were swept up in the mass hysteria, hoping to strike it rich by buying low and selling high. A few did, but most did not.

A single bulb cost as much as a house

The bulb market rocketed out of control so fast it was not uncommon for the price to escalate 20-fold in a single month. In 1637, a single bulb of a particularly popular variety cost 10,000 florins. To put this in perspective, the same amount of money would have bought a nice little house along a canal in Amsterdam.

People who had worked their entire lives for the few possessions they owned began trading everything they owned including that nice little house on the canal just to purchase a single bulb. According to journals kept at the time, one person offered the fee-simple of twelve acres of building ground for a single Harlaem tulip. An Amsterdam variety fetched 4600 florins, a new carriage, two grey horses, and a complete suite of harness.

Munting, an author of that day, preserved the following bill of lading delivered in exchange for a single root of a rare species called the Viceroy:

Two lasts of wheat
Four lasts of rye
Four fat oxen
Eight fat swine
Twelve fat sheep
Two hogsheads of wine
Four tuns (barrels) of beer
Two tuns (barrels) of butter
One thousand lbs. of cheese
A complete bed
A suit of clothes
A silver drinking cup

As the mania spread, major local exchanges continued trading the bulbs without letup, and even expanded the market by offering option contracts to speculators. In essence, this gave those with less money to spend an opportunity to lose even more. Using leverage, one could purchase an option for a fraction of the cost of the actual bulb.

Leverage is risky business, especially if youre putting your prize possessions on the line and hoping that the price will rise enough to not only make up for what you still owe but also to return a sizable profit when you sell.

But people swept up in herd mentality dont stop to consider the risk/reward ratio or, rather, the risk/ruination ratio. Otherwise, they might never have leveraged themselves so fully. They would have stopped to think that the slightest drop in price could mean not only losing their initial investment but going into debt or even complete ruination. But of course, bolstered by lusty and mindless hope, people were mesmerized into believing that prices could go nowhere but up.

When a few of the more savvy speculators heard rumors that the Dutch government would soon attempt to set controls on the market, they started pulling out. Thus began the big unraveling. Buyers balked, sales slowed and prices faltered. But nothing can stop Mother Nature; there were still bulbs in the ground ready to be harvested.

Soon the bulb supply outweighed demand, and a slow downward price spiral began picking up speed. Panic set in. The once vibrant, if unrealistic, market for tulip bulbs quickly lost its luster. In less than six weeks, it ended in a resounding crash.

After sorting through all the bankruptcies and defaults, the supreme judges of Amsterdam simply declared tulip bulb speculation nothing more than gambling. All contracts negotiated during the frenzy were made null and void. In other words: worthless.

There were winners, of course those who jumped in early, understood the psychology of the herd mentality, and got out in time, leaving fools in the rubble. When you compare Tulipmania to the recent bubble in real estate, youd be hard pressed to find a more fitting aphorism: Those who fail to learn from history are destined to repeat it.
About Author Jose D. Roncal And Jose N. Abbo :

Co-authors Jose D. Roncal and Jose N. Abbo share some 50 years of senior executive experience in international business, finance and economics. Both have authored numerous articles on business strategy, finance, accounting, capital markets and the global economy. For more on the authors and their book, The Big Gamble: Are You Investing or Speculating?, visit: <a href="http://www.financialspeculation.com" target="_blank">http://www.financialspeculation.com</a>.


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Article Added on Friday, November 7, 2008
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