As we discussed in last episode, the tulip bulbs had risen to tremendously high prices.
More and more people joined the tulip trade hoping to buy a couple of bulbs now and sell
them for a profit later. But the price only increased because people were expecting it
to increase.
You might think to yourself “how is this any different from gold or company shares
today? People often buy it in the hope that it will be worth more in the future”.
Well, the difference here is that both of these goods provide actual value to many people
and are thus valuable for more than just being a tradable good. We use gold in wedding rings,
a medium of exchange, and in electronic. It creates value for you. Jewelry, while being
a luxury, still provides value. If, like in the past, you can only buy something using
gold, then you will want gold in order to buy the things you want to have. And electronics
are valuable so you can watch my videos. Likewise, company shares give you value because you
now own part of a company and you receive dividend. And sure, a tulip has value because
it’s pretty... But not 10 YEARS of salaries pretty. This is what makes a bubble a bubble:
the actual value of the product is a lot lower than the amount of money for which it is traded.
And the price was just going up endlessly it seemed.
What is important to remember is that nobody, at the time, knew for certain what would happen.
This was the first bubble so nobody was sure what would happen in the end… The very idea
of a bubble didn't even exist yet, there was no previous experience to draw upon… To
most people it just seemed like business as usual… most people… But not all. The prices
were becoming so high, that some people couldn't help but wonder if maybe… Just maybe the
prices were too high, if maybe… just maybe they WOULDN'T keep increasing in price in
the future, and if maybe… Just maybe, they should sell their tulips before the price
would drop. But even though disquiet had been building,
the end still came sudden and unexpected.
It is the evening of February 5th, 1637. The traders have come together inside an Inn in
the Dutch city of Haarlem. The men buy a drink, light a cigar, and warm up at the fire. Soon,
the trading is about to begin. As the men take their seat, the first bulb is being presented.
It is a small bulb, weighing less than half a gram. It’s of a valuable breed but not
even close to mature yet. The men start bidding and it’s sold for 56 Guilders, about 2 months
worth of salary for a carpenter. Next, another man shows his tulips, this time on a piece
of paper. It reads that the owner of this contract will be able to collect a bulb weighing
about 5 grams… still not mature yet. The men look at each other… But nobody makes
an offer. Nobody thinks they can make a profit on this bulb. Nobody is willing to take the
risk. Eventually an offer IS made, but it's lower than expected. It is sold for only 10
Guilders. That's okay, the trader thinks, he will just make a profit the next time.
This isn't so bad, just a one-time setback… right? Another tulip trader comes and shows
his own wares. A piece of paper is presented: A mature bulb weighing over 50 grams. Again
the men look around, again nobody bites, and again the merchants only buy it for a much
lower price than expected. The men start getting nervous… The price
appears to be going down… Not up. They have tulips of their own. Tulips that are now worth
far less than at the beginning of that evening. So they decide to sell their tulips now, instead
of waiting for the price to drop further. And as soon as some traders start selling,
the price goes down because there are now more tulips being sold. So in order to compete
with the other traders, they now have to lower their price. But as the prices get lower,
more traders sell their tulips, meaning they are forced to lower their prices even more,
leading to even more people selling, leading to even lower prices, meaning more people
sell, meaning lower… [DO THIS FOR A BIT. MAKE IT A GAME DUNGEON JOKE WHERE YOU GO ON
AND ON AND THEN JUST CUT OFF THE SOUND IN EDITING]. This cycle continued throughout
the evening. Until by the end of the night, prices had fallen dramatically. By some estimates,
prices had dropped by as much as 95%... 95 PERCENT in a SINGLE night.
And what had happened in Haarlem spread to other cities. Some traders decided to be crafty
and took a horse to the nearest city and sell all their now-worthless bulbs before prices
in other cities would crash as well. And as buyers, sellers, and collectors travelled,
prices crashed across the country. Within four days the bubble had burst across the
Dutch Republic...
So, what happened? Why did nobody see this coming? And an even more important question:
how come this cycle has repeated itself so many times since this first crisis? Why wasn't
the first financial bubble the last? Well, this question can, in large part, be
explained with 1 simple answer: trust. During the bubble there were prominent traders who
everybody looked up to as sources of trustworthy information. And they said that tulip bulbs
are a good investment. So, if you don't know enough about the business to make your own
assessment, you trust someone else's. Just as you trust a car mechanic about cars, a
carpenter about wood, and a doctor about medicine. And so, people trusted traders about trade.
But what happens if they are wrong? Well, you get a bad investment at best and a financial
bubble at worst. To compare this with a modern day example:
The crisis of 2008 happened because we trusted otherwise-trustworthy rating agencies on so
called ‘sub-prime’ mortgages. They said they were good investments while in reality
they weren't. And so banks, investors, and borrowers trusted them to be a safe investments.
But when it turned out they weren't, the bubble burst and an economic crises was created.
Just as people trusted tulips to be a safe investment because other, more knowledgeable
and more experienced traders said they were… and when it turned out they weren't, the bubble
burst, and people lost a lot of money.
I hope you learned something here. Not just a fun story to tell at a party or at the dinner
table, but I hope that you learned some actual economic concepts: that a financial bubble
isn't created by a couple of evil guys sitting in a room plotting doom, but rather that it's
a process of one risky investment after another. In the first episode we talked about how tulips
were introduced to the Netherlands and became an expensive luxury product. Then the merchants
started a lucrative, albeit exclusive, trade in tulips. Then a future contract was introduced,
allowing people to trade papers stating the ownerships of tulips, rather than the flowers
themselves. That led to more people trading in them and as more people traded, the price
went up and up until eventually it just didn’t anymore. And then it crashed.
So who is to blame here? Was it the original traders? The futures contract? Allowing new
people to join the trade? Or… are none of them to blame and is it just a course of events
leading to an unfortunate end result? You tell me. I'm not going to tell you what to
think, I think my audience is smart enough to form their own opinion. But I hope that
now you understand how an economic bubble happens. That it is not some evil master plan
set in motion years ago, but rather, a series of seemingly-good decisions that benefitted
the individual but resulted in the collapse of the trade for the collective.
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