Economic Bubbles and Tulipmania
Economic bubbles occur when assets grows far beyond their intrinsic value, driven by speculation. Economic bubbles are just like regular soap bubbles. They are something that eventually pops. That is the definition as far as I am concerned. People blow them into existence for fun, watch them fly and burst into nothing. Everybody knows a bubble when they see it, but most only afterwards.
One characteristic of economic bubbles is the dissociation between an asset and its price. The asset under question becomes almost irrelevant. People are more interested in other people. They say to themselves: ” I wonder how much I could trade this for. I don’t really care what it’s worth, how much can I get for it “. This is pure speculation by all definitions of the word, and a bubble is speculation gone rogue.
Economic bubbles have occurred many, many times throughout human history. Let’s take a look at one which I think you’ll find interesting.
Enter Tulipmania
Tulipmania was one of the first economic bubbles ever recorded. Tulips were introduced to the then über-wealthy Dutch people late in the 1500s. They went on to be a super big deal. If there was one thing the Dutch loved more than clogs, it was tulips.
Now, I have to admit that these flowers are absolutely gorgeous. Who wouldn’t want to be surrounded by beautiful luscious tulips all day? As a matter of fact, nobody of substance at the time would ever be seen without tulips. The tulip became the status symbol of the day, like an old-timey Gucci or Louis Vuitton. Tulips were in fashion. They had sex appeal.
All of this makes sense so far, wealthy people lavishing money on a product to demonstrate their wealth. But come 1634 things began to change. Most notably, a new job came into existence known as “tulip-jobbers”. Tulip-jobbers were not procurers of tulips, they didn’t farm tulips. They were merely the middle-men of the market. Speculators in an every more frenzied race for that tulip money. According to Extraordinary Popular Delusions and the Madness of Crowds:
“The tulip-jobbers speculated in the rise and fall of the tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and one after the other, they rushed to the tulip-marts, like flies around a honey-pot.”
— Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds.
Life was good, tulip-jobbers made a fortune and beggars lived like kings for a while. At least according to Charles Mackay.
Then it all came crashing down. Charles Mackay:
“Confidence was destroyed, and a universal panic set upon the dealers.”
…
“Many who, for a brief season, had emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption.”
What Happened?
The reasons for the rise and fall of the tulip price are disputed even today. Some economists think the rise and fall of the tulip markets was due to changing supply and demand dynamics. They believe that Tulipmania was consistent with the behavior of rational actors and their perceptions of supply and demand. Some say that there must have been an underestimation of the ability to cultivate tulips, coupled with waning demand. Upon realizing their folly the price fell rapidly.
In Memoirs of Extraordinary Popular Delusions, it is said that, after the fall in price, a court decision was made which voided all contracts made before November 1636. It is also said that the courts mainly refused to consult on the matter because they considered the practice gambling. The result of this was a widespread decrease in trust. The informal contracts had faced little scrutiny while the price was rising, however the rapid fall in tulip prices exposed holes in their legitimacy. It is likely that this distrust hastened the decline of the market.
Even today when bubbles burst we see legal issues come forward, legal issues which didn’t exist when the market was flying high.
Fact or Fiction?
Some scholars question the extent to which Tulipmania actually occurred as written. They think that Charles Mackay may have embellished things a bit. This is likely true. The tulip crisis didn’t crash the Netherlands, which was the wealthiest country in the world at the time, and for a long time afterwards.
However, I believe in Tulipmania because, well the evidence is in our nature. People haven’t changed. This keeps happening over and over again my friends.
I believe in Tulipmania because, well, the evidence is in our nature.
People sometimes even collude together to start their own speculative bubble and profit off of the people left “holding the bag” at the top of the bubble. This type of scheme is known as a “pump and dump” scheme. It’s similar to what is depicted in the movie Wolf of Wall Street. The people who orchestrate a pump and dump are known as “pumpers“. That’s why you have to watch out for people who pump up stocks too much — try to see if they are blowing hot air.
Is this relevant?
We are seeing a resurgence in speculation. This much is almost indisputable. The savings of individuals are through the roof in Canada and elsewhere. With the influx of new money through initiatives like Biden’s anticipated stimulus package more money is entering into the US economy as well. Young people, at least in Canada, have higher savings than before. Young people like to take risks. More people are at home, giving them ample free time to throw money at the stock market. This much is obvious.
Of course, nobody knows what is going to happen in the future. I sure don’t. There are reasons to the contrary, reasons to say that there is no way that we are in a stock market bubble. Many will point to the low government interest rates, others to the vaccine and the potential for real GDP growth in Canada this year. However, I would say it is wise to be careful out there. Don’t sell the farm to try and hitch a ride on the bitcoin wagon, don’t be left holding the bag at the top of the next short-squeeze.
What we do know is that we are entering a new time, emerging back out into the world slowly but surely from the COVID pandemic that hit the world so hard. Things are changing, money is flowing into new industries and out of one’s that reigned during COVID-19. Certain industries are almost certain to experience some major price declines sometime in the near future, such as many members of the technology industry. In fact, this is already underway.
The Greater Fool
I want to wrap this up with the Greater Fool Theory. In poker, I think they use the term “fish”. The Greater Fool Theory indicates that:
There is always money to be made on an asset, so long as there is a greater fool willing to take it from you at a higher price.
So then, the question becomes: who is the greater fool? You better find out who they are because if you can’t see them… well, it could very well be you.
