How Tulips Broke the Market: A Case Study
I was out eating lunch the other day and I overheard someone talking about one of my favorite economic tales. A tale of triumph, sadness, despair, and (economic) depression. It’s a tale. . . about tulips. You may have heard a brief telling if you have ever seen the movie Wall Street: Money Never Sleeps (another Celt favorite). However, there is so much more to the story than ‘irrational exuberance’.
I would like to share this story with my readers. It holds a lot of interesting financial nuances, human psychology, and topics of government regulation. You will also learn something about your own financial knowledge. Come, get yourself a drink, and let’s have story time.
Tulips and Merchant Petaling (ba dum tss)
This tale takes us to the Dutch Empire in the 1550’s when an ambassador from the Ottoman Empire sent over tulip bulbs and seeds to Vienna, Austria. From there seeds emigrated all over Europe and eventually made their way to the Netherlands. Tulips were an instant hit with the Dutch due to their intense colors. However, the production of the tulips for mass consumption would still take another 40 years. Tulips take about 7-12 years to start blooming heavily.
The seeds and bulbs that were given to Europe from the Middle East were fine; however, soon these color rich tulips began to grow striations, bars, and even flames in their flower patterns. These were prized variations and worth much more than a standard single-color tulip. Interestingly enough, what the Dutch didn’t know was that these color distortions was the result of the Tulip Breaking Virus or TBV. A tulip and lilac based virus that creates weaker petals and shorter stems that causes the flower to “break apart” much quicker than a healthy bulb. People were spending more and more money on a diseased flower.
One thing often overlooked in Tulipmania is that tulips were already a luxury item. These things didn’t come cheap, even before the bubble. The merchant class – freshly wealthy from the East Indies trade routes – and the aristocrats were some of the only people that could possess these flowers. The tulip market increased steadily through the 1600’s and began to reach manic phase around 1634. It’s reported that master craftsman were turning to finance and making their yearly salary every month trading tulips.
The Tulip Market Crashes
In finance, we have futures and we have options. While these are both derivatives there are distinct differences. One of the most important differences is that an option has the right, but not an obligation, to buy the underlying asset that you’ve bet on. A future has the right, and the obligation, to buy the underlying asset at the end of the contract. This is where the problem comes. Tulips only bloom for about a week or so during the year. This is the only time that tulip bulbs actually changed hands. Through the rest of the year florists traded, effectively, futures contracts for tulips. That is, they purchase the right to buy a tulip bulb during the next season.
At this point, it’s probably worth telling you all a little secret. The Dutch government banned gambling. The Dutch also banned the buying and selling of goods that weren’t actually owned (i.e. these futures contracts). While the government knew this was happening, they didn’t prosecute any of the florists trading futures. What they did do was tell them that it was a civil issue and the contracts unenforceable in court. I think we can see where the cookie is about to crumble.
February 1637 in Dutch city of Haarlem they have a Bubonic Plague outbreak. Futures contracts come due in March. This will be one of the last auctions before the trading season ends. Just one problem – no buyers show due to the Plague. That leaves sellers, who months ago were carpenters or blacksmiths, holding a bunch of tulip contracts they can’t fill. The sellers panic and begin to offload these contracts as quick as possible and news spreads that people aren’t buying tulips anymore. The price of the tulip contracted so quickly and buyers, not bound by these unenforceable gambling contracts, chose not to pay the sellers. The resulting turmoil of lost fortunes plunged the Netherlands into an economic depression and ended the Dutch Golden Age. The wealth created by trading in the East Indies for the last hundred years was lost, for the most part, between 1634 and 1637.
What can we learn from this tale? Well, for one, DON’T TRADE REAL ESTATE FOR A FLOWER (yes, it actually happened)! More importantly though, don’t fall for the hype. By that I mean, it’s okay to dabble in a crazed bull market. But don’t bet your savings that you’ve worked so hard to amass. For instance, I have a Roth IRA that I save money in that is my “retirement”. However, I also have an independent trading account that is my play money. If I lose it, I lose it. That’s where I make a lot of my risky investments – like Fitbit.
Another thing we can learn from Tulipmania is just how the bubble developed. The tulip was already a luxury item, so it fetched a high price. During this craze the price of the actual tulip bulb went up quite a bit; however the price of the future contract is what really exploded. In financial terms that means price of betting on the market cost more than the actual good they were betting on. Generally, not a good sign. For those who are in the know, I’m not talking about the intrinsic value, but rather the extrinsic. Ultimately, just keep the faith. Make sure you know why you’re investing and stick to your long-term plans.