“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one”
– Charles Mackay, 1841.
History has a way of repeating itself. Unfortunately for us it is only looking back retrospectively that we come to realize this. Lessons are learned and then swiftly forgotten. In an age of globalization it is more important than ever that we strive to learn from our past. This is especially true with regards to the financial world. Increased interdependence in economies resulting from global trade has created a situation where isolated booms and busts have become a thing of the past. It is part of human nature to think that the future will be better than the past, and that eponymous phrase from Reinhart and Rogoff’s important book on financial crises, that this time is different; this leads to short term thinking which is an extremely dangerous thing given our current situation.
In this blog I will draw parallels between Tulip mania that effected the Dutch in the early 17th century, widely considered to be the first recorded economic bubble, and the sub-prime mortgage crisis that brought about the global recession we are experiencing today. By doing this I hope to make clear that despite appearing to be very different, there are key characteristics that are shared by all financial crises in any time. The message of this blog is simple, if something seems too good to be true, it usually is. In an area that affects every member of society in a world that is increasingly interlinked it is imperative we learn our lessons and proceed into the future with caution.
(Dublin 4, At the heart of Ireland’s property bubble)
The parallels between the US and the Netherlands at the time of the crises are clear to see. The Dutch during their golden age and the US in the 20th century were both seen as preeminent economies at the time, excelling in areas such as trade, science and the military. While the Dutch were not the superpower the US were at the time its fair to draw a comparison between the two thriving economies.
A key difference between the two crises is clear to see, and that is the information available regarding them. In an age of endless databases and analyses the underlying causes of the current global crises are available for those who want them. Contrasting this the information surrounding ‘Tulipomania’ is sketchy at best. Until the 1980’s Charles Mackay’s famous book ‘Extraordinary popular delusions and the madness of crowds’ was the key source of information regarding this bubble. Since then his addressing of the crisis has been questioned regarding its sensationalist nature, but there are still lessons to be learnt.
The central story to Tulip mania is one of irrational speculation and the attachment of prices to objects that far surpass their intrinsic value. The same can be seen in house prices around the world in recent years. In Ireland properties were purchased that doubled or tripled in value in just a few short years. The low interest rates available in the US in the post-dotcom era and intense competition between mortgage lenders for market share lead to mortgages being given to those with questionable credit ratings and then repackaged by the banks to avoid liability on their part. House prices rose and wealth created seemingly out of nowhere. Throughout the history of finance, (not that long in the scale of things), bubbles have burst and been compared to this original example. Each time in retrospect Nassim Taleb’s Black Swan theory may be applied. They are events that cause major impacts and are only rationalized in retrospect.
(Sharp drop off in tulip prices)
The exact events surrounding Tulip mania are unclear, yet the story persists in the form of an economic old wives’ tale. It is known however that as the bubble grew from around 1634 to 1637 the class of individuals involved shifted. Those who had not formerly been involved in the business saw opportunities for quick wealth creation and the middle class became involved in bulb trading. It is generally agreed to have shifted in this direction around 1636. This embedded the eventual burst more deeply into the economy than had it remained within the original bulb trading community. Once again this mirrors the expansion of the property market in the US to those who had not previously been deemed suitable for mortgages.
The financial tools utilized by the Dutch at the time evolved to meet the growing bubble. An innovative futures market was developed for the first time. This left many vulnerable to an extent not realized until after the bursting of the bubble. At the time of expansion it appeared to be a fantastic tool in realizing potential growth prospects of the market, yet in retrospect caused more problems than it solved.
(The Sub-Prime mortgage crisis lead to record numbers of home foreclosures)
The utilization of more complicated and interlinked financial tools such as mortgage securitization and collateralized debt obligations to shift liability is an evolution of this original innovation. While appearing to offer solutions in the financial world, these tools were instead shown to have devestating capabilities.
The eventual crash associated with both bubbles was profoundly different due to the time they inhabited. Tulip mania affected only a small percentage of people to limiting degrees, while the sub-prime mortgage crisis went on to have devastating global effects which are only still being realized today.
(Admirael van der Eijck, one of the most prized tulips)
The frequency of financial crises are increasing and their effects are becoming more severe. The fragility of financial systems, various amplifying factors, regulatory failures and the collapse of asset prices are now issues of such importance that we cannot afford not to learn from the past again. I’m sure this is a sentiment that has been toted before, but in an age of increasing global interdependence I fear these issues will only grow more important. Tulip mania stands as the original reminder of the irrational nature of bubbles, but the current crisis is surely one of the most important.
Each time a recession or bubble occurs the old adage is proclaimed: this time is different. Unfortunately with increasing frequency and devastation associated with these crises we will sink or swim based on our ability to learn from the past.
“This time is different.” Reinhart, C.M. & Rogoff, K.S. Princeton University Press, (2009).
“Irrational Exuberance.” Shiller, R.J. Princeton University Press, (2005).
“Extraordinary popular delusions and the madness of crowds.” Mackey, C. Harriman House Limited, (1841).
“The Black Swan: The Impact of the Highly Improbable.” Taleb, N.N. Allen Lane, (2007).
“Manias, panics and crashes – A history of financial crises.” Kindleberger, C.P. & Aliber, R. Palgrave Macmillan, (1978).
“Famous first bubbles: The fundamentals of first manias” Garber, P.M. The MIT Press, (2000).
“Tulipomania: The story of the world’s most coveted flower and the extraordinary passions it aroused.” Dash, M. Crown, (2000).
“Global financial meltdown: how we can avoid the next economic crisis.” Read, C. Palgrave Macmillan, (2009).
“The Historic Link Between Tulips and The Sub-Prime Mortgage Debacle.” Ficke, G. SelfGrowth.com
Prof. Brian Lucey, TCD. JS Applied Finance lecture slides.