Was tulipmania irrational?

By Paul Walker 07/10/2013

It is often assumed that the tulipmania was the result of financial market irrationality and the mania is often used as an example of said irrationality. These idea were popularised by Charles Mackay, a mid-19th century Scottish writer. Mackay is best known for his book, Extraordinary Popular Delusions and The Madness of Crowds. But was the tulipmania really all about irrational markets. Some economic historians say no and provide alternative explanations for what happened.

Some of these alternatives are discussed in an article at the Economist‘s blog Free Exchange.

First start with the work of Peter Garber including this 1989 paper in the Journal of Political Economy, “Tulipmania”. Garber also has a book, Famous First Bubbles: The Fundamentals of Early Manias. In short Garber argues that the tulipmania was not simply irrational trade in rare bulbs. As the Economist puts it:

Peter Garber blames the general public for the price increases. He reckons that an outbreak of bubonic plague in Amsterdam made people less risk-averse. Dutch city-dwellers knew that each day could be their last—so did not mind indulging in a little speculation. And because gambling was illegal, contracts were unenforceable. If traders misjudged the market, they could just run off without paying.

But on the whole, Mr Garber reckons that investors acted rationally. He suggests that the trend towards extremely high prices, followed by rapid declines, was typical for rare bulbs, due to their growing cycle. And according to Nicolaas Posthumus, a Dutch historian, serious tulip financiers generally did not participate in the speculative markets. Any “mania” was pretty self-contained, and was pushed forward by casual traders, drunk on jenever and moral hazard. Only in the month before the crash does Mr Garber find evidence of speculation from more serious traders.

Then there is E. A. Thompson’s 2007 paper in Public Choice which asks “The tulipmania: Fact or artifact?”. The Economist continues,

Earl Thompson, formerly of UCLA, takes a different approach. He reckons that the market for tulips was an efficient response to changing financial regulation—in particular, the anticipated government conversion of futures contracts into options contracts. This ruse was dreamt up by government officials, who themselves were keen to make a quick buck from the tulip trade.

In plain English, investors who had bought the right to buy tulips in the future were no longer obliged to buy them. If the market price was not high enough for investors’ liking, they could pay a small fine and cancel the contract. The balance between risk and reward in the tulip market was skewed massively in investors’ favour. The inevitable result was a huge increase in tulip options prices […]. (The price of options collapsed when the government saw sense and cancelled the contracts.) Spot prices (the price that traders paid for immediate delivery of tulips) and futures prices (the prices that traders would be compelled to pay for future delivery of tulips) were not volatile. And any movement of the spot/futures price was determined by simple supply and demand—the fall-out from the Thirty Years’ War, one of the bloodiest in European history, was one important factor.

Thompson argued that popular interpretations of tulipmania have failed to distinguish between options and futures. Tulipmania was only a contractual artifact. There was no “mania” at all.

Is there a lesson here? Perhaps it is that it is all too easy to say that bubbles are irrational since they seem to represent a deviation of prices from fundamental values. But to understand these “deviations” we need to understand how speculation actually works and there has been little effort put into doing this. The Economist’s article closes by saying,

The example of tulipmania shows the importance of doing that—rather than relying on lazy quips about “animal spirits” or irrationality.