Tuesday, September 30, 2008

Let's talk tulips

'cos nothing else makes much sense

"If a weaver scraped together, say, 50 guilders, he might buy a new loom and increment his income slightly. But if he invested the same amount on a bulb he could make a small fortune quickly by speculating on a commodity whose value had never fallen."

That's from one of the best economic historians Australia has produced - Trevor Skyes. As he says in this after-dinner speech delivered to an Australian Reserve Bank conference in 2003:

"I'm not sure I need to give the rest of this speech, because we can all see where it's heading, can't we?"

But the ride is wonderful, and tells us that so much that is new is old again... a good, if awful, feeling.

The full talk, Tulips from Amsterdam, is here.

Below the fold I'll summarise by selecting choice paragraphs..

Tulips from Amsterdam

"There are four key foundation blocks for any hysterical boom.

First, a long period of growing prosperity in which the investing classes enjoy
a rising tide of disposable income – as Australia enjoyed in the 1960s ahead of the
nickel boom. And the deeper this prosperity spreads downward into society, the
better the chance of a boom because disposable income is in the hands of people
who are inexperienced at investing it.

Second, the arrival of an exciting new commodity or industry, such as railways
in the United States in the mid-19th century or Silicon Valley in the late 20th. And,
the early investors in that industry should be showing substantial returns, thereby
attracting more risk capital. Typically, there is a long groundswell in a commodity
price before it goes wild.

Third, within that commodity or industry there should be one or two star performers,
such as Poseidon in the nickel boom or Microsoft in Silicon Valley.
Fourth, a marketplace that is liquid and unregulated enough for prices to

By 1636, Holland had all four ingredients.

The merchants were growing rich on the Indies trade. Tulips were a status symbol
and – as the years went by – were becoming increasingly accessible by the lowerpaid
members of society.

And there was a star performer. Rosen tulips were one of the most highly prized
varieties, and the most highly prized of them all was the Semper Augustus.
It had a slender stem which carried the flower well clear of the leaves, showing
off its colours to best effect. The base of the flower was solid blue, turning quickly
to pure white, while slim blood-coloured flares shot up all six petals and around
their tips.

Everyone in Holland agreed that tulips were beautiful. Now came the widespread
realisation that a fortune could be made from them. The prices of tulips had been
rising steadily since their arrival in Holland. The early investors from 1630 were
showing rich returns.

By 1633, tulips were becoming widely available in Holland, although the most
prized were still scarce and expensive. But in 1633, we have the first recorded
instance of tulips being used as money, when a house in the town of Hoorn changed
hands for three bulbs.

From then, the prices started rising strongly.

The Semper Augustus, priced at 5,500 guilders in 1633, hit 10,000 in January 1637.
At that price only a handful of Dutchmen could have afforded it. It was enough to
feed, clothe and house a Dutch family for half a lifetime. Or, enough to buy one of
the grandest homes on the most fashionable Amsterdam canals for cash, complete
with a coach-house and 80ft garden, at a time when Amsterdam property was the
most expensive on earth.

At that date, a big-time merchant might have been making 20 000 guilders a
year. So a single bulb of Semper Augustus was worth half his income. As a modern
equivalent, one tulip bulb was worth half Rene Rivkin's income.

Bulbs had already been used as a unit of exchange. Now they became a promissory
note – a scrap of paper listing the variety and weight of the bulb, the name of the
owner and the date upon which it would be lifted. Because the lifting date was
usually several months away, this encouraged dealing in the piece of paper rather
than the bulb.

What we are talking about here is a future.

The futures market was not entirely novel to Holland. The very earliest futures
markets had been organised in Amsterdam 30 years earlier by merchants who traded
in timber, hemp or spices on the Amsterdam Stock Exchange.

However, the traders in tulip futures were gambling upon an essentially unknown
commodity. If I buy a future on BHP shares, I know what I'm getting upon delivery
(or at least I hope I do).

But when I buy a future on a broken bulb I don't know what sort of flower I'll
have upon delivery.

But that no longer matters, because the buyer is no longer a botanist or gardener
who wants to own a beautiful fl ower. The buyer is only interested in the bit of paper,
which he hopes to trade at a profit.

So yes, the tulip was the underlying commodity that fuelled the boom of 1636–37,
but in reality it was leveraged into a derivatives boom. And one of the characteristics
of derivatives is that few of the traders are ever interested in final delivery.

So in Holland in 1636, it became perfectly normal for a florist to sell bulbs he
could not deliver to buyers who did not have the cash to pay for them and no desire
to plant them.

The second ingredient was leverage. Where bulbs or offsets were not available
for instant delivery, it was common to put only 10 per cent of the price down.
Also, the buyers quickly worked out that they could build a fortune faster if they
borrowed to buy tulips, or futures on tulips. So they began mortgaging their homes
to play the bulb market.

I mentioned earlier that weights of bulbs were one indicator given to speculators.
A healthy tulip bulb increases in size while in the ground. So if prices on weight
stay constant, the bulb will increase in value as it grows.

Artisans on low wages had been making money slowly. If a weaver scraped
together, say, 50 guilders, he might buy a new loom and increment his income
slightly. But if he invested the same amount on a bulb he could make a small fortune
quickly by speculating on a commodity whose value had never fallen.

And if he leveraged by borrowing, he could make a medium to large fortune.

I listed earlier the four requisites for a hysterical boom. We now have three of
them. We have a prospering society with surplus investible cash. Not only are the
rich investing but the middle classes are getting into the act, so there's volume. We
have a prized commodity which has never fallen in price. We have a bunch of star
performers, led by Semper Augustus. All we need is a marketplace.

Tulips were never traded on the Amsterdam Stock Exchange, which in any case
only traded from noon until 2 pm. Tulips were an unregulated market.

Tulip trading happened in taverns, mostly in Haarlem, where the participants
were quite frequently drunk. And sometimes the taverns doubled as brothels, which
would seem about the perfect ambience for an unregulated derivatives market.

The taverns were very smoky and the inhabitants drank vast quantities of wine
and beer. Each deal struck was followed by a toast. And this was in the days when
wine in Dutch taverns was served in pewter pitchers that held anywhere from two
pints to more than a gallon. The mania of December 1636 and January 1637 occurred
in this drunken, licentious ambience.

The deals were usually done on slates. A bidder would write down the price he
wanted to pay, a seller would write down the price he would accept. The slates were
passed to intermediaries nominated by the principals, who would write down what
they considered a fair price, which was not necessarily in the middle.

The slates were passed back to the buyer and seller. If either of them did not
agree, they would rub out the price. If the deal was struck, the buyer would pay a
commission, usually around 3 guilders, to the seller. The commission was called
‘wine money'.

One flaw in this system was that there were no credit checks. Buyers did not
have to prove they had the money to pay for the bulbs. Sellers did not have to prove
they owned the bulbs they sold. So the taverns combined unbridled speculation,
stimulated by alcohol, while providing no safeguards for anyone.

Like most booms, the end came suddenly. On the fi rst Tuesday in February, a
group of fl orists gathered as usual in a Haarlem tavern to offer pound-goods for
sale. One member offered a pound of Switsers for 1 250 guilders, a fair price in the
market then. He received no bids. Nobody wanted to buy.

From there, panic spread in the market. Nobody wanted to buy tulips
any more.

The collapse was so sudden and complete that there is virtually no information
on post-boom prices. The only buyers left were a few rich connoisseurs who did
not depend on the trade for their wealth.

According to one anecdote a tulip that had been worth 5 000 guilders before the
crash was later sold for only 50. A bed which would have fetched 600 to 1 000 guilders
in January, changed hands for only 6.

The collapse was total and very fast. Even the great modern computer-aided
meltdown of October 1987 did not produce such instant eradication of wealth.

What happened was that the market had been killed from the bottom. The very
cheapest tulips had been driven so high in price that there was nothing for new entrants
in the market to buy (which looks a lot like the current Sydney real estate boom).
With no fresh money coming in from the bottom, the boom lost its foundation.

And, of course, as soon as any over-priced commodity reaches its peak and turns,
every trader becomes a seller trying to get out as quickly as possible and destroying
prices as he sells down.

The pain of the crash was worst for those who had borrowed to speculate. Men
who had pledged their farms and houses suddenly lost them. In the days before social
security that meant the workhouse or starvation and probably early death."