Was Tulipmania the Madness of Crowds?

Tulipmania – was it really “the Madness of Crowds”? The Seventeenth century was the golden age for the Netherlands. Trade, industry, science, and art were all blooming. Some of the reasons for this development were immigration of qualified employees to the country, its location at the intersection of East-West and North-South trade routes, cheap energy from windmills, from peat flowing to cities through canals, and the invention of the sawmill that enabled the Netherlands to create its commercial and war fleets. At the time Amsterdam was one of the richest cities in the world, if not the richest. It was both the financial center and main trade center of the world. A stock exchange was established there in 1602, and though it was not the first one in history, it was, however, as a French historian Fernand Braudel wrote, the first stock exchange with such high turnover, liquidity, and freedom of speculation in transactions. This is why some people call it the first modern stock exchange. It was created in connection to the formation of large trade companies, such as the Dutch East India Company which is considered to be the first international corporation and the first company to issue shares and securities.

It is also considered the largest and the most valuable corporation in history. These big companies, however, drew their strength from monopolistic privileges granted to them by the authorities, one example being exclusiveness of trade with the lands these companies reached. The Bank of Amsterdam was founded in 1609. Let us return to this topic in a moment. Industry in the Netherlands was also booming, and its shipyards and sugar factories blossomed. Agricultural production increased as well. In the seventeenth century the Netherlands one’s social status gradually became more and more determined by income than by birth, making merchants the dominant class in society and allowing them, as it were, to buy into the upper classes. The society’s wealth grew. A well-known flower, the tulip, became one of the symbols of high status. Tulips came to Europe from Turkey. Initially, they appeared in Vienna, and then in the Netherlands. In Europe tulips were considered exotic plants at that time. Their colors were much more intense than those of other flowers known then to Europeans. And so tulips quickly became a very desirable luxury good. They were separated into different categories according to colors: from ordinary one-colored to multicolor varieties, like tulips with white stripes on red or lilac petals. Let us note that broken colors of multicolored tulips was caused by an infection with a virus called tulip mosaic virus or tulip breaking virus. We know it now. The symptoms were known in the seventeenth century, but nobody linked the effect to the virus, and the infected flowers were considered beautiful.
Nevertheless, the virus caused weakening and slower growth of plants as well as impaired development of bulbs. The virus spread only through the tulip’s bulbs and not through its seeds, so infected bulbs were particularly sought-after on the market for this particular effect. But as a result of the disease the supply of such bulbs was reduced, thus increasing their prices. Their breeders assigned to these rare varieties various names such as Semper Augustus, Admiral Van der Eyck, or Viceroy. In 1634, speculators entered the tulip market, attracted by high demand for bulbs in France. From that moment people bought the bulbs not only to plant them in gardens, but also to profit from their rising prices. Prices continued to rise until they reached levels that at first glance may seem absurd to us. Thus began tulipmania. The story of the mania was popularized by Charles Mackay in his book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, first published in 1841. He describes it as follows:

“The tulip-jobbers speculated in the rise and fall of the tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favoured clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney-sweeps and old clotheswomen, dabbled in tulips. People of all grades converted their property into cash, and invested it in flowers. Houses and lands were offered for sale at ruinously low prices, or assigned in payment of bargains made at the tulip-mart. Foreigners became smitten with the same frenzy, and money poured into Holland from all directions. The prices of the necessaries of life rose again by degrees: houses and lands, horses and carriages, and luxuries of every sort, rose in value with them, and for some months Holland seemed the very antechamber of Plutus.”

Mackay also writes that two last of wheat, four lasts of rye, four fat oxen, eight fat swine, twelve fat sheep, two hogsheads of wine, four tuns of beer, two tons of butter, one thousand pounds of cheese, a complete bed, a suit of clothes, and a silver drinking cup were delivered for a single root of the rare Viceroy variety. The total value of the transaction was 2,500 florins. By comparison, the average wage of a skilled worker at the time amounted to 150 florins a year. According to Mackay it was not the most valuable tulip at all. Semper Augustus variety was considered very cheap at 5,500 florins; once a person even offered twelve acres of building ground for it.
To understand the specificity of the bulb trade, we must briefly talk about their cultivation.
Tulips bloom in April and May. To avoid destroying the plants, the bulbs have to be removed from the ground not sooner than in June, but must be replanted in September. This is why trading in bulbs can only take place from June to September. In all other months all exchanges have to be conducted as futures contracts. Because of that clients only buy a promise of having bulbs delivered after their harvest is possible. As American economist Peter Garber writes in his article Tulipmania, thus in the seventeenth century Netherlands formal futures markets developed, and were organized in taverns and took place in groups called “colleges.” The buyers were required to pay a small percentage of the contracted amount, and no margin nor margin deposits to guarantee compliance were required. Typically, the buyer did not currently possess the cash to be delivered on the settlement date and the seller did not currently possess the bulb, so only a payment of the difference between the contract and settlement price was expected. The contracts themselves were also traded and some accounts indicate that a single contract could change hands several times a day. The speculative mania reached its peak between 1636 and 1637. It encompassed not only prices of bulbs of rare tulips, but near its end also prices of common tulips. The prices skyrocketed, as in case of the Witte Croonen variety. Its price multiplied by a factor of 26, and then after the bubble burst it dropped to 1/20 of its peak in February 1637. And February 1637 is precisely when the tulip bubble burst. It started in the city of Haarlem, where for the first time none of the clients appeared at the auction. Some explain this disappearance with the plague that afflicted the Netherlands at the time. The bubble burst in the winter when bulbs were safely underground, so the problem was what to do with the futures contracts. According to American economist Earl Thompson, a large organization of Dutch florists and planters announced in a decision later ratified by the parliament that the buyers of all contracts made between November 30, 1636 and the reopening of the cash market in Spring were relieved of their unconditional obligations to buy the future tulips at the specified contract price, although they had to compensate the planters with a small percentage of their contract prices.
Mackay describes the bursting of the bubble as follows:

“At last, however, the more prudent began to see that this folly could not last for ever. Rich people no longer bought the flowers to keep them in their gardens, but to sell them again at cent per cent profit. It was seen that somebody must lose fearfully in the end. As this conviction spread, prices fell, and never rose again. Confidence was destroyed, and a universal panic seized upon the dealers. […] Defaulters were announced day after day in all the towns of Holland. Hundreds who, a few months previously, had begun to doubt that there was such a thing as poverty in the land, suddenly found themselves the possessors of a few bulbs, which nobody would buy, even though they offered them at one quarter of the sums they had paid for them. The cry of distress resounded everywhere, and each man accused his neighbour. The few who had contrived to enrich themselves hid their wealth from the knowledge of their fellow citizens, and invested it in the English or other funds. Many who, for a brief season, had emerged from the humbler walks of life, were cast back into their original obscurity. Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption.”

Mackay’s story, although still popular and often quoted in discussions of the tulipmania, is not really respected by economists and historians. It is based mainly on religiously motivated pamphlets against speculation that tell a story about evils of dealing with material matters instead of focusing on spiritual ones. Scientific credibility of such sources is low, because they most probably exaggerate their depictions of the events. Economists call into question both the scale of speculation, and the extent of consequences of the bubble bursting. Some even deny the very existence of the speculative mania. They admit that the tulip bulbs actually reached prices that seem gargantuan to us, and that thereafter the prices fell sharply, but these critics claim that even then the prices were in tune with the fundamentals. The analysis of the issue presents a challenge, as the data is rather inaccessible, incomplete and incomparable. But in spite of that, several potential scientific explanations of the phenomenon exist and together they form a certain story. Needless to say, the discussion between economists is, as usual, far from conclusion. Prepare yourself though, as that these explanations are somewhat intricate.

One such economist, Peter Garber, argues that mania is an inadequate term for the tulip market at the beginning of the seventeenth century. In Tulipmania he compares prices of new varieties of tulips with historically later prices of new varieties of hyacinths, and then he analyzes their price declines in the long run. What Garber finds is that on the flower market extremely high initial prices of rare varieties of flowers are not really such an anomaly. He also finds that there is nothing strange about prices falling to a fraction of their initial value. In addition, Garber compares the long-term decline in prices during the tulipmania with similar phenomena in later periods, which are not considered manias nor bubbles. He notes that the annual rates at which prices declined are similar in all cases and amount to around 40%. He finds that even in modern history the prices of new prototype varieties can reach amazing prices. One of his examples is a new variety of lilies. A small quantity of its bulbs were sold for the equivalent of $480,000 at 1987 exchange rates of guilder, apparently proving that very high prices for rare plants are not necessarily a sign of the “madness of crowds.” He concludes that most of the 1634 to 1637 period was nothing like such a madness. He admits, however, that his study does not explain the huge increase in prices of ordinary common bulbs in the last month of speculation and concludes that it may signify a potential bubble.

Another economist who tackled the topic is Earl Thompson with his article The Tulipmania: Fact or Artifact? He uses a more complete data set of the period in order to refute Garber’s conclusions. Thompson finds that although in the long run the annual price drop could amount to around 40%, in the three months after the peak of the bubble, prices fell more sharply and more violently. According to Thompson, prices declined by as much as 99.999%. Thompson disagrees with Garber as for the causes of the situation. As mentioned, the buyers of all futures contracts made between November 30, 1636 and the reopening of the cash market in spring could pay only a small percentage of the contracted price in order to back away from buying the tulips at contracted price. Thompson writes that in effect this decision basically converted the futures into options contracts. The difference is that in case of futures contracts buyers have an obligation to purchase at specified contract price, and in case of options the obligation disappears leaving buyers with the right to either buy at specified contract price, or resign and incur only relatively small fees. Thompson further explains that this legislation was publicly discussed much earlier. His wider examination of the entire tulip boom period reveals that after 1634 both prices and the number of tulip trade participants were rising until in October 1636 the prices suddenly declined in the first crash. Thompson argues that the collapse was caused by the news of the Battle of Wittstock, where at the start of October 1636 Germans were suddenly defeated by the French. German princes eagerly bought tulips to decorate their summer estates, and threats from the French as well as from domestic rebels could hamper their demand. Many people, including state officials, lost a lot of money during the decline. According to Thompson the debates about market futures that started in the aftermath led market participants to expect with a high degree of certainty that all futures contracts made after the October collapse would be legally changed into options. These expectations caused the sudden rise in prices. People figured that they will profit in case of spot price exceeding contracted price, and in the opposite scenario they will simply refuse to buy bulbs; this expectation caused the prices to skyrocket. Thompson points out that well informed speculators, officials and breeders could make up for losses by setting a different date of conversion of contracts than what was previously announced:

“Settling on a November 30th rather than an October termination date for the original contracts heavily favored, besides the planters, those speculators who sold contracts in late November to individuals who held the common expectation that contracts written in November would be options rather than futures contracts. The negotiating public officials, being much more informed than the public, could therefore more than offset their losses on their earlier purchases by selling contracts in late November, when, based on the previous announcements of the trusted public officials, the buyers had already begun treating the contract prices as option strike prices set at around 10 times the actual prices […].”

Thompson concludes that the entire speculative mania in December 1636 and in January 1637 was already carried out based on the expectation that it would be possible to simply abandon the purchase of bulbs. He further indicates that in this period the prices of the actual futures contracts that were to end in actual sales already decreased substantially. The humongous prices of exercising options between December and the crash were never realized. The real victims of the whole situation with conversion were November buyers who thought falsely that they will not have to pay the contracted price.

American economist Douglas French takes another stance in his book Early Speculative Bubbles and Increases in the Supply of Money. French studies the impact of monetary factors on the speculative bubble, focusing in particular on significant rise in money supply. The starting point in his analysis is the introduction of free coinage laws in the late sixteenth century Netherlands. Free coinage meant that the state will mint coins out of any quantity of metal delivered to it. The provider of the metal was to receive the minted coin free of charge or for a very small fee. The law attracted gold owners who tried to avoid high minting fees charged by other rulers. The trade in Amsterdam was carried out mainly with foreign coins, and the local ones were used only to a small extent. Introduction of new coins into circulation was difficult at the time, because according to Gresham-Copernicus law “bad money drives out good”, and foreign coins were often of poor quality. To remedy this, the Bank of Amsterdam was originated in 1609. The Bank accepted the coins as deposits based not on the face value of the coins, but on the metal weight or intrinsic value of the coins. In turn, depositors received banknotes that were convenient in use. A single currency was thus created. The City of Amsterdam guaranteed the security of deposits, and the Bank of Amsterdam did not grant loans at that time, and as such operated as a full-reserve bank. Because of the convenience and the security, people deposited their coin eagerly, and the bank money was even traded at a premium over coins.

The free coinage laws combined with the stability of the Bank of Amsterdam, as well as increased trade and treasures confiscated in international waters by the Dutch fleet, caused a huge influx of silver and gold to Amsterdam followed by an increase in the supply of coins. French calculated that from 1633 to 1638 the deposits at the Bank grew by 60%. On the basis of Austrian business cycle theory French argues that this surge in the money supply was the main cause of the speculative mania.

Garber claims that tulipmania could not cause too much misallocation of resources such as land, because the largest speculation in its entirety took place when the bulbs were in the ground and it was impossible to plant more. French points out, however, that the effects of the bust were significant and noticeable, as that the number of bankruptcies doubled between 1635 and 1637.

French contends that:

“The story of Tulipmania is not only about tulips and their price movements, and certainly studying the ‘fundamentals of the tulip market’ does not explain the occurrence of this speculative bubble. The price of tulips only served as a manifestation of the end result of a government policy that expanded the quantity of money and thus fostered an environment for speculation and malinvestment.”

He also admits that the episode differs from present-day experience:

“But what made this situation unique was that the government policy did not expand the supply of money through fractional-reserve banking, which is the modern tool. Actually, it was quite the opposite that occurred. As kings throughout Europe debased their currencies, through clipping, sweating, or by decree, the Dutch provided a sound currency policy which called for money to be backed 100 percent by specie. This policy, combined with the occasional seizure of bullion and coin from Spanish ships on the high seas, served to attract coin and bullion from throughout the world. The end result was a large increase in the supply of coin and bullion in 1630s Amsterdam. Free coinage laws then served to create more money from this increased supply of coin and bullion than what the market demanded.”