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Asset bubbles have always been a testimony to the bizarre things that humans can accomplish when they abandon their own rational thinking and a herd mentality sets in. However, the case in point of the first asset bubble in recorded history i.e. the tulip mania brings this to light.
The sheer absurdity of the situation that existed is a testimony to the fact that markets are not self-correcting, not at least in the short run. In this article, we will have a closer look at the Tulip Mania.
Asset bubbles always start with perceived or real prosperity. In the case of Holland, the prosperity was real. Holland had just entered its Golden Age. The Dutch traders were exploiting the newly found trade routes between Europe and Asia.
Exotic goods like spices were being imported and sold for as much as 400% profit! This created a very wealthy class of people in Holland. This nouveau riche class was always searching for more avenues to flaunt their wealth and distinguish themselves from the average Dutchman. Their quest for display of status led them to tulips. Little did anyone know, that the Dutch fascination with Tulips would cause them to lose about 4 decades as far as their economy was concerned.
The Dutch merchants and royalty were fond of living in mansions surrounded by beautiful flowers and tulips caught their fancy. This was because tulips were extremely rare. They were not grown in Holland. In fact, they had to be imported from Turkey at that time although later cultivation started in Holland because of the rising demand.
Also, tulips took many years to grow to make their supply scarce. Tulips that were infected by a particular kind of virus were also in high demand in Holland, and they were even scarcer. Tulips were also durable and could last long enough for them to be traded in the market.
The fact that the Dutch had a seemingly insatiable demand for tulips and that the supply was extremely limited led to the creation of a tulip exchange. Here there were traders whose sole means of earning livelihood was buying and selling tulips.
Some of these buyers were buying tulips and hoarding them. This increased the scarcity, the perceived demand as well as the prices.
Some buyers also had forward contracts that allowed them to purchase the tulips that were due to be delivered at a later date. Traders who were good at their skill could earn thousands of florins per month which would be the modern day equivalent of hundreds of thousands of dollars! An entire financial ecosystem was built around a so-called “asset class” which had no intrinsic value at all.
The tulip mania ended up taking a life of its own. At the peak of the bubble, tulip bulbs were selling for nine times the average Dutchman’s wages. This meant that the average Dutchman would have to work for nine years straight and survive without food or water to be able to buy a tulip bulb! The reality was as absurd as it sounds today.
After all, how valuable could a flower really be even if it was a status symbol? The level of absurdity can be gauged from the fact that the prices of tulips went up by a multiple of twenty in the month when the mania hit the peak.
Most investors were not interested in the intrinsic value of the flower though. This was the first time in history that the greater fool theory was being experimented with. Traders who purchased tulips brought them in the hope that a greater fool i.e. another trader would buy it from them at an even higher price.
For quite some time, the prices did keep on rising, and greater fools did appear in the market, and the system worked perfectly. However, the first bubble made the world understand that idiots work on emotions more than logic.
The market sentiment of greed made it seem logical to buy tulips at rising prices. However, when the prices started moving in the opposite direction, the sentiment also turned, and that is when chaos happened. That was the world’s first experience with the bursting of an asset bubble.
The decline in the price of tulips was also as drastic as the rise in the price. In fact, the decline was faster as prices just fell off a cliff. Soon people realized that they had been trading hours of work and in some cases their life’s savings for a small flower! The insanity of the situation became apparent, and people rushed to sell.
The belief amongst investors that they will find a greater fool to buy the flowers at a higher price was shattered. Also unless there was a greater fool willing to buy, tulips were more or less worthless! Hence, once prices started dropping, a domino effect took place and prices settled at a meagre 1% of their former high.
The tulip mania is a testimony to which herd mentality can affect the behavior of an individual. If a single person were to trade their life’s savings for a flower, they would be considered insane. However, when multiple people were doing the same thing, no one noticed the inherent folly in their behavior.
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