New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: Tulip Mania and the South Sea Bubble: Early Financial Bubbles. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
10.1 Dutch Tulip Mania (1637) — The Original Bubble Template
The idea in plain words
Tulip mania was a boom and crash in Dutch tulip-bulb contracts in 1636 and 1637. Cheap bulbs, called pound goods, rose up to twentyfold in January 1637 and collapsed in February. Careful archive research by Anne Goldgar and Peter Garber shows it was smaller and less damaging than the legend told by Charles Mackay in 1841. So use it as a diagram of how bubbles work, not as proof of economic ruin.
Key points
■Traders bought and resold forward contracts for bulbs still in the ground, with little cash down.
■Goldgar found traders were mostly merchants, brewers and craftsmen in Haarlem and Amsterdam, and few bankruptcies.
■Haarlem’s 1638 rule let buyers cancel for 3.5% of the price: on a 1,000-guilder contract worth 100, the loss fell from 900 to 35.
A closer look
In the Dutch Republic in the 1630s, prices for tulip bulbs, rare and fashionable but not productive in any economic sense, rose to levels later retold as worth more than a furnished luxury house in Amsterdam. Over the winter of 1636–37, traders bought and resold forward contracts for bulbs still in the ground, paying little or nothing until delivery, so the trade rested on the expectation that prices would keep rising. In February 1637 buyers stopped turning up and began defaulting on their agreements, and prices collapsed. The cheapest bulbs, sold by weight as pound goods, had risen up to twentyfold in January alone.
Decision rule
Reading rule: before calling any price move a bubble, ask three questions. Can you name a cash flow or use value that justifies the price? Are buyers paying with borrowed money or deferred-payment contracts rather than cash? Is the main reason to buy the expectation of selling higher to someone else? A no to the first question and yes answers to the last two mark the bubble mechanism. Do not use tulip mania as evidence of how much damage a burst bubble does: the archival record shows little.
The costliest mistake
Treating a forward commitment as if it were an option. A buyer who signs a forward at 1,000 and sees the price fall to 100 owes 900; only an outside rule, such as Haarlem’s 3.5% cancellation fee, cut that to 35. In modern markets no such rule arrives: futures are marked to market daily, so the 900 is collected in cash as prices fall. Size any forward or futures position to the full loss at a plausible worst price, not to the cash you put down.
10.2 The South Sea Bubble (1720)
The idea in plain words
The South Sea Company swapped its shares for British government debt, so its profit depended on its share price staying high. Promotion, insider dealing, loans against its own shares and installment sales pushed the price from £128.5 in January 1720 to about £1,050 in the summer. Then it fell to £124 by December. A business that depends on its own share price is fragile once that price turns.
Key points
■At £1,000 a share the company handed debt holders 1 share per £1,000 of debt and could sell the other 9; at par it could sell none.
■Loans on shares and installment payments were leverage that fed demand.
■The Bubble Act of June 1720 made unchartered trading companies illegal and lasted until 1825.
Decision rule
If a company’s profit depends on its own share price staying high, through stock-financed acquisitions, debt-for-equity swaps or loans secured on its own shares, treat a falling share price as a threat to the business itself, not only to shareholders. Ask how much of reported growth would vanish if the stock fell 50%. Ignore this test for companies that issue no stock and lend nothing against it.
The costliest mistake
Buying back in after taking a profit, near the top, because the price keeps rising. Isaac Newton made about £20,000 early in 1720, then put nearly all his money back in; his net worth, just over £30,000 shortly before the bubble, was down to about £20,000 by mid-1721 despite those early gains. A buyer at the £1,050 peak who held to December lost 1 − 124 ÷ 1,050 = 88.2%. Decide your exit rule before the price moves, and do not reset it because others are still making money.
What the full article covers
In the full article I take you through these sections:
■10.1 Dutch Tulip Mania (1637) — The Original Bubble Template
■10.2 The South Sea Bubble (1720)
It includes a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Tulip Mania and the South Sea Bubble: Early Financial Bubbles, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance