Econbrowser

If you talk long enough with someone who's persuaded that today's housing market is experiencing a bubble, the topic eventually is likely to turn to alleged precedents like the Dutch tulip mania. Calculated Risk, the Motley Fool and Seeing the Forest are among those whose fancy this past week turned to thoughts of those old Dutch tulips.

Much of the popular understanding of the Dutch tulip mania is derived from Charles Mackay's delightfully written book, Extraordinary Popular Delusions and the Madness of Crowds , whose first edition appeared in 1841. Nine colorfully narrated pages describe the market for tulips in Holland between 1634 and 1637.

It was not until 1989, however, that the record of this episode was really set straight by the careful research of Peter Garber published in the Journal of Political Economy. Garber documented that the spectacular tulip prices recounted by Mackay never applied to ordinary tulip bulbs, whose prices, even at the height of the frenzy, were quoted like produce by the half-pound or pound. The extraordinary prices characterized instead a few special lines of tulips that had been infected by a mosaic virus which in some circumstances produced a particular pattern judged to be beautiful, such as the Semper Augustus shown at the right. But if you liked the effect in a particular flower, the only way to reproduce it would be to cultivate a few buds from the original, hoping to have two or three bulbs in the following year with the same qualities.

Unlike the modern notion of a bubble as an asset for which market participants believe the price will continue to rise, Garber claimed that tulip cultivators always understood that the price would eventually fall. As long the price falls by less than 50% each year, if the grower was successfully able to cultivate 2 or 3 new bulbs from the original, he would come out ahead, because paying 100 guilder for 1 bulb and next year selling 3 bulbs for 50 guilder each is a winning proposition. In a rational market, the value of the original bulb should equal the discounted present value of the future net proceeds after cultivation costs of the bulbs that could be uniquely produced from the original. Given a market for flowers that values unusually beautiful flowers at a higher price, such a valuation implies that the initial price could be quite high but quickly fall over time as more bulbs like it become available each year. There could be (and was) an initial period in which the price actually rises, and quickly, as growers discover that this particular kind of flower is the one everybody would like to have. But from there the rational equilibrium is one where everybody understands that the price will fall rather rapidly, and knowledge of this reality does not discourage a buyer from paying the initial high price.

And this is precisely the pattern that Garber found, both through the alleged mania and for the centuries afterward for which more thorough data can be assembled. Garber could find no indication that anyone experienced financial distress as a consequence of the decline in prices of some of the fanciest mosaics in 1637, or that the rate of price decline between 1637 and 1642 was significantly different from that seen for other special lines of tulips or hyacinths developed in the 18th and 19th centuries.

It is true that there evolved in certain Dutch taverns a system for buying and selling the year-ahead crop for more common bulbs in which more ordinary people participated for more ordinary sums, in part emulating what they saw going on with the rare bulbs market and hoping to profit on a more modest scale from the popularity of the flower more generally. The brokers of such deals were paid with what was described as "wine money," and such agreements were legally stipulated to be nonbinding for the 1637 harvest. Garber concluded that, if there was anything to the idea of a "bubble" in the tulip markets of this time, it applied to these small-time tavern-negotiated agreements. But Mackay's account would have been far less entertaining had he simply reported the details of these rather modest deals.

And if your next question is, "but what about the Mississippi Scheme or the South-Sea Bubble," I invite you to take a look at Garber's examination of these in his paper published in the Journal of Economic Perspectives in 1990.

I do, by the way, agree with Mackay's principal thesis that our species is prone to believing in something that isn't true just because we see that those around us seem to accept its veracity. I'm just wondering whether the conviction that there was such a thing as a Dutch tulip mania might not itself be an example of such a popular delusion.