I’ve been asked frequently lately: what’s going on with this financial crisis, and why does this happen? So today, I thought I’d talk about tulips.
Tulip Mania 1634 – 1638
In the 16th century Holland’s maritime reach and interests were expanding around the globe. They were exploring and discovering far and wide. In 1593 Conrad Guestner imported a tulip bulb into Holland from Constantinople. Connoisseurs of exotic plants soon also came to buy tulip bulbs. The exotic bulb soon became a status symbol for the wealthy. The desire to own one spread, firstly across the truly wealthy, and then also across the would be wealthy. Over the years some tulip bulbs became infected with a virus which caused them to developed a unique colouring effect in their petals, which made them even more sought-after.
The price of tulip bulbs rose steadily through the 1630s. Speculators were attracted into the market and the price rise started to accelerate. A futures market for bulbs was even created. Big capital returns were made over shorter periods. The mania spread right across the community, including to those who weren’t that wealthy. The price of a single bulb reached astonishing levels.
People sold their entire properties – houses, farms, and stock – to acquire just one single bulb. They could see a potential return of hundreds of percent in a matter of a month or so. Those who probably couldn’t afford it entered the market, also seeking to make a fortune. It was a systemic positive feedback loop: rising prices attracted more buyers, more buyers drove the price yet further up.
Does this sound familiar? Individual greed kicked in, overriding individual prudential behaviour. Emotion dominated reason. The underlying assumption, which many never questioned, was that the price could rise indefinitely.
A drunk man in a bar started peeling and eating what he thought was an onion, while in fact it was the bar owner’s tulip bulb proudly on display. That man was jailed. Prices reached their peak around 1637, and then the tulip market crashed spectacularly. The buyers had stopped. Panic spread across Holland. Traders attempted to prop up demand, but the market had evaporated. It is not possible to create wealth out of thin air. And I don’t know how many glasses of beer I’d need before deciding to eat a tulip bulb.
The South Sea Bubble 1720
A century or so later Britain was in deep debt. In 1711 the government made a deal with a private company – The South Sea Company, whereby that company would finance Britain’s debt in exchange for a guaranteed interest rate on the stock of 6%, and also monopoly trading rights in the South Seas, including in slaves.
The shares were snapped up, more were issued, and they also sold well. Plenty of investment capital was available at the time. But financial success was less than expected during the first few years. In 1718 King George I became governor of the company, creating confidence in the enterprise. The company expected to recoup the debt from expanding trade, and from the foreseen rise in the value of its shares.
The share price soared in 1720 as a result of the company’s proposal to take on a large part of the government debt. It went from around 128 at the beginning of 1720, to around 1000 in August, 1720. But in September it collapsed, and by December they were back down below 124. Many investors were ruined. The House of Commons ordered an inquiry, and found at least three ministers had accepted bribes and speculated. Many of the company directors were disgraced. So: what’s new today?
Mississippi Bubble
Around the same time as the South Sea Bubble, France was experiencing its own bubble:- the Mississippi Bubble. In 1715 France was bankrupt and had defaulted on debt. The Duke of Orleans, on the advice of Scottish gold dealer John Law, established the Banque Generale which took gold and silver deposits and issued metal backed banknotes, like our gold backed system used to be. The banknotes were inflation proof because they were redeemable in the original amount of precious metal. John Law also established the Compagnie d’Occident in 1717 later Compagnie des Indes which had a monopoly on trade with French American territories where there were thought to be reserves of precious metals.
There’s a lot more to the story than I have time for here. However, in a nutshell, the volume of banknotes in circulation was expanded. It did not match the amount of gold and silver on deposit to back it. There were problems converting notes back to specie. Trust in the banknote was violated. The share price rose from 500 livres in 1710 to 10,000 in 1720, and back down to 500 in 1721. So: is anything different today?
President Nixon removed the last remnants of the gold standard in the early 1970s. The US dollar no longer had a gold backing. The US dollar became a fiat currency, and remains so today.
The Roaring Twenties and Crash of 1929
During the roaring twenties the US was experiencing a boom brought about by new technologies, production processes, and company management. The boom was all fuelled by the increased use of credit. It made sense to use other people’s money by putting it to better use than letting it sit idle.
The Dow Jones rose from 100 in 1926 to 381 at its peak in 1929. Two months later it had fallen back down to 145. In 1932 it was down to 45. Speculators, aided by easy credit, fuelled the “blow off”. Does this sound familiar?
Restrictions on credit by the Federal Reserve at the time dried up the money supply and contributed to the depression. This time around, in 2008, the monetary and financial authorities are not making the same mistake. Instead, they are seeking to flood the world with money, early, in anticipation of possible deflation. The chairman of the US Federal Reserve, Prof. Ben Bernanke even has the nickname “Helicopter Ben” because of his comments that deflation could be prevented by mounting a helicopter drop of money into the economy.
Other Bubbles
There have been other bubbles:
- The Japanese Bubble of 1984 – 1989.
- The Crash of 1987.
- The “Dot Com” Technology Bubble and “Tech Wreck” of the 1990s.
Opportunity for Individuals
What does this mean for us? Given the correct knowledge, experience and attitude it is possible to protect yourselves from these situations, and to profit. Right now is the ideal opportunity to learn how to trade, and to put everything in place in preparation for trading the next market phase after the market becomes more stable. Anyone who can cut their teeth during this market will have a solid foundation for great success when circumstances change again. I suspect some in the audience are recoiling in fear at the moment. But ask yourselves, and be honest with yourselves: are you of a nature who will enter the market again near the top? And sell again at the bottom? Are you driven by fear and greed?
Today
So, what is the situation we find ourselves in today? It appears that we’ve got a bubble of greed leveraged up on top of a another bubble of greed. There is the underlying US housing bubble in which inflating house prices and relaxation of bank leverage ratios, and the relaxation or even suspension of other prudential behaviour, led to the positive feedback “tulip effect”. Debt was based on the wrong assumption that house prices can only ever rise. But house prices in the US are now collapsing faster than the mathematical risk models of their securitised collateralised debt obligations.
Moreover, those who should have known better also allowed themselves to be carried away into their own bubble on top of the housing bubble:- the hedge funds; the investment banks; and even the financial insurers.
The major players were issuing credit default swaps and other “over the counter” derivatives to the value of 500 Trillion US dollars, or reportedly even more than that. And these are all off market and unregulated. There is no standardised or organised market, so these assets are so opaque that it is not even possible to determine a market price for them. (Well, it is actually, but to do so would have consequences.) These assets were created based on the assumptions of young mathematical experts who appear to believe that mathematics is reality, and, with a sprinkling of relativism permitting them to reject the notion of absolute mathematical truth, proved mathematically their own “reality”, and that their instruments were really absolutely AAA safe.
These people are really well educated. But it is easy to see that degrees in business, finance, commerce and mathematics do not prevent failure. The financial experts are falling like dominoes. Clearly, there is more to understanding bubbles than a university degree can provide. In fact this brings the whole situation into the realm of each person in the audience. Much about the current financial crisis can be understood from a basic understanding of: mankind, human nature, emotions, greed, fear, hope and despair.
As Aristotle urged: “Know thyself!”.
Can the intrinsic nature of man change? The current circumstances are simply a part of a regular cycle of boom and bust that has occurred throughout history. This is not the end of capitalism. Some of the media is becoming hysterical: emotionally out of hand.
The financial authorities have learned from the great depression, and are responding in an entirely different manner, by opening up liquidity to the tune of trillions of dollars.
Speculation mania recurs time and time again, and always will. Crashes are always needed to bring mankind back down to the reality of earth.
Thank-you.
Sources
We acknowledge the following sources.
- Encyclopaedia Brittanica http://www.stock-market-crash.net/tulip-mania.htm
- Erasmus School of Economics http://people.few.eur.nl/smant/m-economics/johnlaw.htm
Copyright © 2008 Nils Marchant
This is an edited transcript of a talk delivered the Options21 Live Market Briefings during the 15th – 18th of October, 2008.