What common knowledge tells us and the truth of a matter is not always the same thing. Sometimes history is hidden behind stories generated among regular people. One example is the relationship between tulips and economies. The 1000-year history of the tulip, its markets, and its popularity give us the background to understand today’s market volatility and challenges. Understanding the historical contexts in which financial risks are taken makes us smarter risk takers today.
History is full of stories. A story with some traction is that carrots are good for our eyes. This World War II propaganda from the UK led generations of children to eat excessive amounts of carrots based on the false belief that doing so will improve their eyesight. Another false story is that tulips entered Europe from the Middle East in the 16th century, which led to an economic bubble and collapse. People who promote this story tend to believe that it is extremely rational. This story has become so widely accepted in the centuries since that few people even question whether it is true. It is easier to accept and spread the idea than to check the facts. It is efficient to use a well-known meme to spread misinformation, and, when something has become accepted as a fact, it tends to take a great deal of effort to challenge that authority. Even people who do not accept a story often accept the meme, leading to logical inconsistencies in their arguments. This is a concern regarding market bubbles because people who verbally attack markets do so on the belief that ‘markets are not perfect’. However, nowhere in the economic literature are markets seriously described as perfect; they are identified as optimally efficient compared to other options. To promote an alternative to a market-based solution, the proponents of that solution need to demonstrate that their solution is more efficient than the market solution. Because they cannot do that, their strategy is to attack the market. ‘Markets are not efficient or perfect’ is a catch phrase that is used over and over again, but no evidence is offered that an alternative would be economically more efficient. The economic fable of a failed market did not begin in the 17th century; it started with an invented tale created by Charles Mackay [1] in the mid-19th century. At that time, it was not important whether the story was true; what mattered was its impact. Mackay offered no evidence that could withstand scrutiny, but few of us actually take the time to validate facts anyway. Stating that people act wildly when they act together is a good story, and we instinctively enjoy listening to it. The only problem with it is that it isn’t true. There are several problems with tulipmania [4]. Most important, the effects of the so-called ‘tulip crash’ were not as widespread as they were reported to be. Some of the problems with these forms of bubble theory derive from a misunderstanding of the Broken Window fallacy. The belief that we can make more money through destruction and capital creation is widespread, but it is flawed. Foremost is the fact that we have a growing society and capital creation. At all points, we have more capital than we had in the beginning. The simple consequence of this is that destruction (such as the crash that follows a bubble) is not the source of creation. If it were, rational businessmen would tear down their old factories and replace them with new equipment before their depreciation dates. The simple fact that this does not happen demonstrates a flaw in the argument. Many errors have been promulgated about the Dutch tulip crash and little has been done to counter them. The contracts used to buy tulip bulbs were one of the first types of futures contract. These contracts were somewhat similar to over-the-counter derivatives because exchange-based contracts did not exist. Tulip bulbs are seasonally marketed, and they are sold only between June and September. Merchants would market these bulbs throughout the year if it made sense, but that arguably would be risky speculation without a purpose. The reality is far from that contention. Similar to the way that modern exchanges sell grain futures, the early guilds of the 1630s initiated a futures trading scheme. These early futures contracts allowed farmers to select what they would grow and to hedge against the risks associated with everything from the weather to the vagaries of fashion. Like modern futures contracts, early Dutch merchants traded contracts to buy and sell goods at a future time. Many times, merchants decided not to honour the contracts. Just like a modern breach, the courts awarded the monetary difference and did not enforce contractual compliance. This system worked well during the early 1630s, but problems arose in about 1636 when, recognizing that profits could be made in the international tulip trade, a group of government officials decided to get involved. However, these officials were less successful than the merchants; they did not buy well and they suffered losses on their investments. Despite the early failures, these officials predicted some changes to the market and petitioned to work with the florist guild. This intervention led to a formally supported announcement that all of the contracts were only options to buy [6]. The penalty for violating this was limited and similar to option prices in a modern futures exchange. Fortunately, this step was anticipated and the losses were far less than are currently widely believed. Futures contracts in the 1630s were defined as gambling debts. There were longstanding problems regarding the nobility’s wagering of their estates, it was a long-term practice of the courts to refuse to enforce repayment of gambling debts. For example, the Court of Holland decided that tulip sales were bets under Roman law [7]. All futures contracts exhibit power law distributions. For this reason, they are counterintuitive. We instinctively understand Gaussian mathematics regarding normal distributions, but we fail to understand power law processes. It is intuitive to understand that some people are short, others are tall, and heights are distributed in the shape of a bell curve. But, that does not apply to prices or incomes.
So, it is easy to state a maximum and falsely suggest a mean of a distribution. At its peak in 1635, one particular tulip bulb was extremely expensive. This bulb was the ‘Semper Augustus’, and it was the most prized flower in Europe. Its spectacular red ‘flames’ on white petals made it a remarkably beautiful flower, and it was widely sought by European royalty.
The 12 Semper Augustus bulbs sold for high prices because they were the only Semper Augustus bulbs in existence. At its peak demand, we know that this particular flower sold in the Haarlem markets for 6,000 guilders. This was a phenomenally large amount of money at that time equivalent to the cost of 16 fat pigs, eight fat oxen, or 100 tons of wheat. Prices are extremely different now than they were then, and a comparison is difficult. However, 100 tons of wheat traded for GBP 10,000 in 2014. The purchase of a Semper Augustus bulb included all rights to the flower bulb and all derivatives that immediately came from it. To some people, it might seem to be a phenomenally high price for one flower bulb, but the reality is that it is nowhere near as bad as it seems.
In the modern world, excessively high prices are also paid, even during my lifetime. For example, in the flower world, black is a particularly elusive and desirable flower colour. Whenever something is rare and in demand, we can expect it to command astonishingly high prices. In 1997, Thompson & Morgan purchased three hyacinth bulbs from the yearly show in Holland for GBP 150,000. This sum was more than five times that of any tulip bulb. After eight years of cultivation, the progeny of these bulbs went on sale to the public under the marketing name ‘Midnight Mystic’. In 2005, the company sold the bulbs for GBP 7.99 each.
Even this amount might seem excessive to some people, but the company, Thompson & Morgan, holds all rights to sell and market this flower. In 17th-century Europe, before genetic engineering, propagating slow-growing bulbs, such as tulips, was not reliable as a large-scale process. Thompson & Morgan’s financial records indicate that the company is profitable. As expensive as the initial purchase was, the company has propagated and sold enough flowers to generate a profit.
As the above shows, when we make profits we are happy to stand by our gains. It is only when we make a loss that it is easy to call ‘foul’ and blame the market for these losses. It is more honest to follow a practice where we admit our losses. The truth is that any purported losses and gains that exist on paper never come to fruition and hence do not change the overall wealth of society.
POWER LAWS
A power law system is skewed to form a long tail. This is similar to most commodity markets. In other words, when a range of goods of various quality levels or grades plus a strong desire for limited products exists, aspects of the resulting market create long tail prices such as we saw above regarding tulips.
This is different from the traded price. One exercised strike price for a single (exceptional) sale of 12 bulbs did not reflect the entire market. The figure on the right appears to illustrate the tulip bubble. This figure demonstrates the difference between spot futures pricing and the traded, but an exercised strike price of tulips. The first thing to note is that the graph highlights a peak rather than the long term average. More important, what is not reported here is that the price of tulips stabilised and, by 1638, had returned to its 1635 price.
The fallacy in the argument for using exercised strike prices for exceptional goods in a power law system to demonstrate excessive spot prices should be obvious. They simply are not the same. Unfortunately, there is a common but widely held misunderstanding regarding the futures and derivatives market. It is easy to mislead people when they do not understand the difference between a spot price and an unexercised strike price. For example, I could list my house for sale for USD 100 million, although it is worth far less than that, and the house would never sell for that price, but I could use that asking price to mislead people. The irrationality is not in the market.
THE PLAGUE
A rarely reported side note will inform this discussion: In 1636 and 1637, the Plague was ravaging parts of Europe. Haarlem was hit particularly hard during this period, and as many as one in four people in the city died [2]. Many families in the wealthy nobility and merchant class fled the city. This level of disruption tends to change people’s perspectives [3]. In times of great crisis and upheaval, such as the Plague in 1636, we tend to worry most about survival and are more likely to take risks. In this instance, trade in early futures contracts were widely adopted. In modern futures trading, exchange-based futures contracts require margin accounts to lower the risk of default [5]. This innovation did not exist in the 17th century.MORE ADVERSITY
As if the plague were not bad enough, the early to mid-17th century marked the period of the Little Ice Age. During this period, winters are believed to have been about two degrees Centigrade colder than they are today. Winters were reported as bitterly cold, and the growing season was shorter than usual. Food was already scarce, and a significant drop in agricultural productivity caused widespread famine. For many people, gambling on life and death was a common practice. Yet, in many ways, this was a rational reaction because when you do not expect yourself or your family to live very long, there is little reason to be oriented toward the future. Short-term thinking would be the rational response in that context and, in the early 17th century, it was better to chance risky profits now then to build a business over time.
WHY TULIPS?
It is easy to understand why any rare item that is beautiful and in demand would command a high price. But, how did the tulip market begin? For a long time, we believed that the tulip entered Holland some time in the late 16th or early 17th century. The myth tells us that this new flower was widely popular as soon as it was introduced. However, modern science and, in particular, DNA testing and analysis, have debunked this fallacy. Studies, such as those published in the Journal of Economic Botany and summarised in the journal, Science, describe interesting histories of flowers, such as the tulip, definitively documenting the path taken by the tulip to arrive in Europe. In fact, the tulip arrived about 500 years before the Holland bubble incident described above. The 19th-century theory of a tulip bubble was invented, as noted above, to propagate a meme. It has been widely believed for a long time that the tulip was introduced to Europe in the 17th century, but that was only a way to support a false economic theory. As is often the case, the truth is stranger than the fiction. Thus, the tulip was widely available in Europe from at least the 11th century and possibly earlier. At that point, the yellow petals on the simple tulip was called the Macedonian Onion. There were no variations at that time. Many people do not know that today it is a common practice to plant tulip bulbs around castles and to hold festivals to celebrate the planting of tulip bulbs. Many of our current traditions are followed without question or knowledge of how they came about, similar to Morris dancing. Planting bulbs on castle grounds is a common practice in many areas although, for villagers and peasants of the 13th through the 15th centuries, it would not have been an activity meant to increase agricultural production. At the time, the amount of food available could be critical by spring, so any way to increase yields could be the difference between life and death. So, why would people plant flowering bulbs on castle grounds? The main challenge to answering this question today is our inability to see the world with the eyes of the past. For the feudal villager, the castle represented society and safety, and a large area around the castle was cleared so that the castle guards would be able to see an attack well before it occurred. If the trees were to grow throughout the grounds and close to the castle walls, attackers could hide undercover and launch surprise attacks. Today, grass might be the ground cover of choice because it is easy to plant and maintain. But, nearly 1000 years ago, there were no weed killers and riding mowers was many centuries from being invented. When tulip flowers die down, thick mats of leaves cover the ground and prevent the growth of woody weeds and trees.CONCLUSION
A contract is a legal promise. In modern futures systems traded over an exchange, margin accounts are used to minimise risk. But, that does not prevent over-the-counter exchanges and contracts. For these, the risk of default always should be incorporated into the price. It is always important to account for the risks associated with an exchange and account for the risk in the profit expected from the exchange. There is never a scenario in which the counterparty cannot collapse or negate a deal in another way. To the other party, the risk of default might be small. For this reason, when a contract is important, it is necessary to ensure that the other party’s commitment is tangible, not only monetarily, but also regarding time and reputation. Mackay [1] greatly overstated the losses associated with the collapse of the tulip market after the courts and guilds became involved. When people believe that their exchanges will not be enforced, it is more likely that their behaviour will become more reckless. The risk taking behaviour seems reckless from the perspective of those looking in from the outside. However, we cannot determine that it is reckless behaviour when, due to unforeseen circumstances, it seems likely that one of the parties of the exchange could die before fulfilling his or her end of the bargain. In 17th-century Europe, unexpected deaths were a real possibility because the Plague was an imminent danger. People who lose in high-risk exchanges often complain that the exchanges were unfair. When their profits are high, they are happy; however, the other side of any exchange is the potential for loss. Many times, loss associated with so-called economic bubbles result from perceived beliefs and fears that the aggrieved party will be ‘bailed out’, that losses will somehow be magically recovered, and that one can gain from the risk when it is positive but not suffer from it when it is negative. This belief incentivises greed. When we reward people and companies by bailing them out of losses, we encourage them to take bigger risks that potentially lead to larger losses. Bubbles are not the result of free markets; they are the result of interventions in the market.References
[1] Mackay, Charles (1841). Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. I (1 ed.). London: Richard Bentley. Retrieved 29 April 2015.Mackay, Charles (1841). Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. II (1 ed.). London: Richard Bentley. Retrieved 29 April 2015.Mackay, Charles (1841). Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. III (1 ed.). London: Richard Bentley.
[2] Terence Ranger and Paul Slack, eds., Epidemics and ideas. Essays on the historical perception of pestilence. (Cambridge: Cambridge University Press, 1992.).
[3] A. C. DeSerpa, A Theory of the Economics of Time, The Economic Journal, Vol. 81, №324 (Dec., 1971), pp. 828–846, Published by: Wiley on behalf of the Royal Economic Society, http://www.jstor.org/stable/2230320.
[4] Calvo, Guillermo A. 1987. “Tulipmania” in The New Palgrave: A Dictionary of Economics. John Eatwell, Murray Milgate, and Peter Newman, eds. 4 vols. New York: Stockton Press.
[5] Garber, P. M. (1989). ‘Tulipmania’. Journal of Political Economy, 535–560.
[6] Thompson, Earl A., The tulipmania: Fact or artifact?, Journal of Public Choice, Vol. 130, №1, Pp 99–114, http://dx.doi.org/10.1007/s11127-006-9074-4.
[7] Gelderblom, Oscar, and Jonker, Joost. n.d. “Amsterdam as the cradle of modern futures and options trading, 1550–1650.” Unpublished paper. Utrecht University.
[8] Hull, John. 2006. Options, futures, and other derivatives. Upper Saddle River, N.J.: Pearson/Prentice Hall.