When Bubbles Burst Tulips. Dot-coms. Hey, manias happen. But most don't lead to economic disaster.
By Justin Fox

(FORTUNE Magazine) – It is, surely, the most told tale in financial history: In 1630s Holland, prices for tulip bulbs soared in a way that would have done early Yahoo investors proud. A bulb of an exceptionally prized and rare variety could sell for as much as a house on the best canal in Amsterdam. At the height of the mania, during the plague winter of 1636-37, traders huddled in taverns and frantically bought and sold futures on third-rate bulbs for sums greater than what they could have hoped to earn in a decade at their previous job of shopkeeper or artisan or laborer.

The speculative frenzy couldn't go on forever, and it didn't. On the first Tuesday of February 1637, prices stopped going up. Because participants in the tulip futures market were following what's now known as the greater-fool theory of investing (that is, they paid such spectacularly high prices on the assumption that some other nitwit would come along willing to pay even more), the market almost immediately collapsed.

It wasn't the first pricking of a speculative bubble, and it certainly wouldn't be the last. But the tale of the tulips was memorable and, unlike most other market phenomena, it doesn't require a Ph.D. in economics to understand. Its most important popularizer was Charles Mackay, a Scottish newspaperman and poet whose entertaining but unreliable 1841 book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, tells of the tulips and two more complicated 18th-century financial bubbles--France's Mississippi scheme and Britain's South Sea episode--before delving into the likes of alchemy, witch hunts, and the Crusades. The book is a perennial favorite on Wall Street: Financier Bernard Baruch recommended it in the 1930s, and in March 2000 money manager Ron Baron handed out copies to all 42 of his employees (at least that's what it says in the latest Baron Funds semiannual report).

The tulip episode also figures prominently in such widely read surveys of financial history as Charles Kindleberger's Manias, Panics, and Crashes and John Kenneth Galbraith's A Short History of Financial Euphoria. And with the tech- stock boom of the late 1990s came a veritable tulipomania mania. A quick check of Dow Jones News Retrieval's database returns 433 articles mentioning "tulipmania" or "tulip mania" since the beginning of 1999--and that's excluding all mentions of the annual Tulipmania flower festival on San Francisco's Pier 39. Two new popular histories of the tulip frenzy appeared in 1999 to great interest (most of the tulip-related history in this article is taken from one of them, Tulipomania, by Mike Dash), as did a novel, Tulip Fever, the motion picture rights to which are now in the hands of one Steven Spielberg. That year also saw the high-profile publication of Devil Take the Hindmost, a history of financial speculation that of course included a section on tulips. In 2000 economist Peter Garber came out with a book called Famous First Bubbles in which he argued that investors in tulips, the Mississippi scheme, and the South Sea Co. were actually acting rationally--perhaps a soothing notion to a modern reader who happened to be neck deep in dot-com stocks, although in Garber's telling it turns out that even rational investors can lose all their money.

There's nothing wrong with all this attention to preposterously expensive flowers--nothing wrong at all. But now that the Nasdaq bubble has popped, we really don't need anybody to remind us--for the next few years at least--that what goes up in financial markets can just as easily come crashing down. What would be far more useful is some clue as to what comes next. The stock market (or at least the part of the market that investors had become most infatuated with) has undeniably crashed. Does that mean it will stay down? Does it mean a depression is ahead? Does it mean the dawning of an austere era in which Wall Street is a dirty word (well, two words), risk taking is frowned upon, and musical comedies featuring tap dancers dominate the box office?

That last riff is, of course, a reference to the excruciatingly austere decade that followed the speculative bubble of the 1920s and the Great Crash of 1929. If tulips dominate the popular view of what speculative manias look like on the way up, it is the Great Depression that most people--at least in the U.S.--have in mind when they talk about what happens afterward.

In this view, reinforced by such works as John Kenneth Galbraith's The Great Crash 1929, the hard times were the inevitable result of the giddy excess that went before. That moralistic interpretation isn't new. In 17th-century Holland pamphlets and artwork castigating tulip speculators were churned out for years after the crash. "The elite viewed this degeneration of business into gambling with deep misgivings," writes historian Simon Schama in The Embarrassment of Riches--yes, yet another serious book with stuff about tulips in it. "It was the contagion of pandemia: The gullible masses driven to folly and ruin by their thirst for unearned gain."

Disdain for speculation and for unearned gain has been a common thread in popular discussion of market bubbles ever since. It isn't an entirely misguided attitude. If all of us spent all our time playing the markets, the actual economic activity upon which those markets rely would presumably cease. What's more, most of us simply aren't very good at speculating and are likely to lose money at it. But none of that proves that financial speculation is always a bad thing or that it invariably leads to big trouble.

If it did, then every speculative bubble should as a matter of course result in economic disaster. And even the most superficial reading of economic history reveals that that simply is not the case.

To begin with, the tulips: Although Mackay writes, "The commerce of the country suffered a severe shock, from which it was years ere it recovered"--and many subsequent chroniclers have simply accepted his claim as truth--historians who have actually looked through the archives have found nothing to back it up. Prices on financial markets (Amsterdam already had a stock exchange at the time) kept on rising well after 1637, and there is absolutely no evidence of widespread economic distress. In fact, the tulip craze played out smack in the middle of the Netherlands' economic Golden Age, a time when the country became the richest in Europe.

Of the other two early bubbles mentioned in Mackay's book, Britain's South Sea episode--in which a company formed to refinance government debt quickly turned into a pyramid scheme that inspired scores of imitators--seems to have left few if any economic scars. However, John Law's Mississippi scheme in France, an even more ambitious bit of financial engineering that involved both refinancing the French government's debt and issuing vast quantities of money in the novel form of paper, does appear to have caused real economic turmoil when it collapsed.

In general, though, it's probably a mistake to attach too much significance to the economic consequences (or lack thereof) of 17th- and 18th-century financial crises. That's because starting in the late 18th century, the economies of first Britain and then Continental Europe and the U.S. were transformed. And the dawning Industrial Revolution, with its voracious appetite for capital to build factories and machines, meant that financial market fluctuations would have a much bigger impact on overall economic activity than they'd had in the days of tulipomania.

The first century of industrialization saw repeated cycles of investor euphoria--for canals, railroads, electricity, and scores of other less significant innovations--each followed by busts in which oodles of companies went under and thousands of speculators lost their shirts (among them, according to family legend, this writer's great-grandfather, who lost nearly everything in the Panic of 1893). The more significant of the crashes had an economic impact that went far beyond punishing those who played the markets.

The reasons for the impact were twofold: First, investor enthusiasm could lead to overinvestment in the new technology. That is, if more railroads were built than were needed to satisfy current demand, railroad building would grind to a halt and with it all the economic activity surrounding the construction of railroads. A few years later demand might catch up, and all those railroads would be put to productive use, but in the meantime the economy was subject to a significant drag. The other economic danger was that financial distress would lead to bank panics, which, when they happened--and they happened a lot in 19th-century America--shut off the cash spigot on which the new industrial economy depended.

Still, things usually got better before too long. The estimates of U.S. gross national product from 1869 to 1918 compiled by University of California at Berkeley economist Christina Romer show downturns, sure, but none that lasted more than two years. Not surprisingly, most economists of the time tended to believe that the downswings of the business cycle were unavoidable, even healthy, correctives to the excesses of the good times.

Which helps explain why, in the early 1930s, economist Joseph Schumpeter told his Harvard students--as memorably recounted by one of them, Robert Heilbroner, in his book The Worldly Philosophers--"Chentlemen, you are vorried about the Depression. You should not be. For capitalism, depression is a good cold douche." ("Douche," in just about every Western European language other than English, means "shower.")

But the Depression of the 1930s was more than just a cold shower. It was far and away the worst economic disaster the industrialized world has ever experienced. Nothing else even compares. And while popular accounts of the tragedy tend to place most of the blame for what followed on the exuberant, excessive 1920s (it was all Jay Gatsby's fault!), that's not the way economists see it. In their view the main reason the stock market crash was followed not by a run-of-the-mill recession but by a wrenching, seemingly unending depression was that central bankers in the U.S. and elsewhere royally screwed up.

Milton Friedman and Anna Schwartz, in their 1963 epic, A Monetary History of the United States, 1867-1960, were the first to make the case that overly tight monetary policy was the chief cause of the Great Depression. For a long time that was a controversial view. It isn't anymore. What happened in the 1930s, economists now almost universally agree, is that the Fed and other central banks around the world were so concerned with trying to maintain the international gold standard, which had been wobbling ever since the outbreak of World War I, that they ignored the needs of their national economies. Or, to put it in terms that a modern reader might better understand, the Fed effectively started jacking up interest rates a year before the Crash of 1929, and kept raising them (or at least didn't ease them) for almost four years afterward. And when banks started failing around the world in 1931, the Fed and its overseas counterparts didn't do anything (or at least didn't do enough) to halt the panic.

As the aggressive actions of Alan Greenspan's Fed during the past few months and in the midst of the global financial scare of 1998 attest, those mistakes probably aren't going to be repeated. In post-war America, market crashes simply haven't been allowed to cause major economic problems. Yes, the collapse of the Nifty Fifty stock market boom in 1973 and 1974 (a far steeper decline in the overall stock market, as represented by the S&P 500, than the recent crash) coincided with a recession, but the oil crisis, not the stock market, is usually fingered as the culprit. And the harrowing 1987 crash (again sharper, although less prolonged, than the 2000-01 variety) seems to have had no impact on the economy at all.

It is true that Americans now have far more of their wealth tied up in the stock market than they did in 1973 or 1987, and that this wealth effect provides yet another channel for financial market fluctuations to be transmitted to the real economy. It's also probably true that economic policymakers will eventually find new, as yet undreamed-of mistakes to make. But the history of the 1929 Crash and of other bubble collapses that didn't lead to great depressions does seem to suggest that, for things to get really horrible, something more than just a 60% Nasdaq drop has to happen.

And it could, it could: A continued rise in energy prices, a boneheaded move by a President or central banker somewhere, a bond market crisis, a plague, a war, you name it--this is not a risk-free world. If anything, it seems to have become a tad riskier lately. Japan is mired in a post-bubble slump with depression-like staying power, although its severity is nothing at all like the real thing. In Southeast Asia, the crash of 1997 resulted in economic downturns that packed nearly as much wallop as the Great Depression, particularly in Indonesia, but didn't last nearly as long. Again, there are causes for those slumps beyond the mere collapse of financial bubbles: In Japan the flurry of asset write-offs, bankruptcies, and other efforts to begin anew that usually follow a financial market crash in a capitalist economy--and typically clear the way for a recovery--have, for reasons both cultural and legal, been happening in infuriating slow motion. In Indonesia the heavy reliance on investment denominated in foreign currencies meant that the country's central bank really couldn't follow an expansionary monetary policy, since it had no control over the Japanese, European, and American money that mattered most to the economy. The country's political instability didn't help either.

All in all, it's hard not to conclude that speculative bubbles have gotten a bad rap. Yes, by steering investment in the wrong direction (or too far in the right direction), they can cause economic pain. But they cannot, by themselves, wreak true economic havoc. And there is a long history of investment bubbles helping pave the way for major technological and economic advances--albeit advances that generally become apparent only long after the bubble has deflated.

That this has been true for railroads, electricity, and automobiles is widely known. But it may even be the case for tulips. Think about it: By giving the Dutch a huge head start over their European neighbors in tulip "technology," the mania of the 1630s laid the groundwork for what is now, according to the Flower Council of Holland, a $4 billion industry employing more than 90,000 people. The Dutch tulip fields are even providing employment to at least one American dot-com refugee, according to an article that recently appeared in Silicon Valley's hometown newspaper, the San Jose Mercury News. To be sure, the formerly wealthy 22-year-old is simply helping out on the bulb farm owned by his girlfriend's family. But it's nevertheless a pretty powerful testament to the fact that even the most seemingly absurd investment manias don't have to end in disaster.

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