Tulip Mania and the Earliest Derivatives

Opinion Pieces>Tulip Mania and the Earliest Derivatives

Long before Adam Smith wrote his magnum opus, The Wealth of Nations (1776), capitalism was alive and well in the United Provinces of the Dutch Republic. This was the Dutch Golden Age, the time of Rembrandt, Christiaan Huygens, Johannes Vermeer, and the home of the earliest roots of modern financial capitalism. Amsterdam was the site of the world’s first stock exchange, established in 1602, and the first ever company to trade bonds and stocks to the public was the Dutch East India Company, trading on the Amsterdam Stock Exchange.

Tulip Mania

Thanks in large part to the influx of skilled Protestant merchants and tradesmen in the late 1500s – fleeing religious persecution under the rule of the Roman Catholic Habsburg King Philip II of Spain – the new Dutch Republic, and particularly Amsterdam, became a natural settling point for these well-educated and hard-working immigrants, possessed with a Protestant work ethic and exciting new ideas of finance and capitalism. “In the Netherlands,” writes Werner Sombart, the German historian and sociologist who devoted his life’s work to recording a detailed history of capitalism in his three volume tome, Der Moderne Kapitalismus (1902), “an entire people became imbued with the capitalist spirit; so much so, that in the 17th century, Holland was universally regarded as the land of capitalism par excellence; it was envied by all other nations, who put forth their keenest endeavours in their desire to emulate it.” The Dutch Republic became a shining light in the new world of capitalism, with a growing and educated middleclass that became fixated on the new ideas of money, business and trade. It was the first time in history in which a person of ordinary standing could own a part of a company – even one of the largest companies in the world. The ideas of bonds and shares effectively broke the iron grip of feudalism – a past in which only nobility could access and prosper from the greater financial and economic system.

This new economic paradigm allowed the Dutch Republic to flourish, and for much of the 17th century, it was the foremost economic power, with an unbeatable maritime force, the highest per capita income in the world, and the global hub for international trade, art and science. And whilst a rapidly evolving and democratised economic system unlocked the potential of private investor’s finances to public companies, it also brought with it the madness of crowds – and the world’s first financial bubble, known as Tulip Mania.

Today one can buy a handful of tulip bulbs for the price of a decent lunch. In 1636, a select handful of tulip bulbs could be traded for every house on the street of a middle-class suburb. This was the height of the Tulip Mania in the Dutch Republic, with a single bulb yielding up to 4 000 florins to the seller. These bulbs had names such as The Semper Augustus or The Viceroy and their value was roughly equivalent to the sum of 10 years’ salary for a skilled craftsman such as a carpenter at the time, estimated close to almost $500 000 in today’s terms.

The most expensive tulips, the variety prized above all others, were of a striped or “flaming” colouration. These beautiful and rare flowers, often of a vibrant red or purple colour with white streaks, were however a complete coincidence of nature. Whilst fanatical growers believed the emergence of a flaming tulip in their garden meant that they possessed the golden source of future flaming varieties, this was not in fact true. As would only be much later discovered, the real source of the exotic colouration of rare varieties, such as the much-sought-after Viceroy and Semper Augustus, was ironically a mosaic plant virus, known as the tulip-breaking virus, which caused the dramatic streaking effect on the tulip’s petals. However, in the 1630s, two hundred years before the emergence of genetics as a scientific discipline, even the most dedicated and knowledgeable tulip growers had no idea how the flaming tulip came to be – a phenomenon that perhaps further added to the mystique and mania surrounding the coveted flower.

From the initial introduction of the tulip to the Netherlands from the Ottoman Empire in the mid- 16th century, it had always symbolised a certain degree of status, wealth and luxury. This perception can largely be attributed to the association of the earliest tulips in the Western world with important emissaries, wealthy ambassadors and the highest royalty. In fact, the first-ever recorded tulip bulb to reach the Dutch Republic was a gift to the Emperor of the Holy Roman Empire, Ferdinand I, from the Sultan of Turkey, Suleiman the Magnificent. This royal status of ownership, combined with a burgeoning, upwardly-mobile middle class – which had newfound ideas of capitalistic consumerism and for the first time, a healthy supply of disposable income – resulted in a market for tulips that exceeded the common rationality of supply and demand. The price of tulip bulbs became completely unhinged from any logical economic sense of value and it led to one of the first-ever asset pricing bubbles in history. Ultimately, however, it was not the mania related to the status and symbolism of owning a tulip that so greatly inflated – and eventually led to the demise of – the tulip market bubble, but the emergence of new financial instruments that allowed for tremendous speculation on the price of tulip bulbs.

In the Northern Hemisphere, tulip bulbs are planted in the later months of the year, around October, and flower for just a few weeks between the middle of March and the end of May. For the rest of the year, between June and September, the bulbs are dormant, and can be dug up, transported and traded from hand-to-hand on the open market. The original trade of tulips in the Dutch Republic only occurred during this dormant period, when the bulbs could physically change hands. As the esteem and price of the underlying asset began to increase in the early 1600s, however, a new form of exchange started to become popular amongst growers, florists and tulip traders.

To circumvent the hindrance of the small trading window of tulip bulbs, limited by the physical reality of the flower’s dormancy period, florists – meeting in the taverns or “colleges” of Amsterdam – devised what is today effectively known as a futures contract. In these colleges, traders paid a “wine fee” of 2.5% upon entry, with the proceeds used towards providing food and drink to traders, as well as funding the record-keeping of an institution that was effectively an early form of a derivatives exchange. These colleges, or exchanges, facilitated tulip traders to draw up futures contracts – witnessed and recorded by those present – so that they could lock-in a price for the future delivery of bulbs from the seller of the contract at the time of harvesting. And with a futures contract in hand, the trader de facto owned the tulip bulbs detailed in the contract.

At the height of Tulip Mania, peaking in late 1636, speculators from all around Europe were making increasingly large investments into these innovative new contracts. The price of the underlying asset climbed daily and there seemed no end in sight to the upward movement of the market. From what was once a hand-to-hand exchange of physical bulbs, within the limits of the seasonal window, the tulip trade was now predominantly conducted via futures contracts, with the papers that promised the delivery of bulbs changing hands as many as ten times a day, increasing in value each time. So irresistible was this idea that regular Dutch citizens were selling their homes to create liquidity to partake in this seemingly infallible and ever-rising market. At one stage, the price of tulip bulbs exploded twenty-fold in a single month. Even common bulbs, without the rare streaking characteristic, were being sold at irrationally high prices.

Word of untold profits spread across Europe like wildfire, attracting investment from nobility who had never even seen a tulip bulb with their own eyes, but were spending exorbitant amounts on futures contracts. However, as a wholly new financial instrument, these contracts had very little security, if any at all, as no official exchange, government or financial board had attempted to put regulations in place that could guarantee the fulfilment of the contract. And yet, this did not concern traders, as long as they knew they could sell-on the paper for a profit in the very near future. Of course, for the market to keep going up, sellers needed to continually find buyers who were willing to purchase these contracts at a higher price.

On the evening of 5 February 1637, in the Dutch city of Haarlem, tulip traders met at their regular tavern to conduct their nightly business. The college was much emptier than usual, and the mood was dark, as the city was in the throes of a severe bubonic plague outbreak. As trading started, interest was low. There was not the typical frenzied appetite that surrounded the buying and selling of contracts that, in the past, had guaranteed traders would go home with a healthy profit. Those holding contracts from the day before struggled to find willing buyers and gradually began to lower their prices to entice the crowd – but nobody was biting. It was thus, on this night, that traders in Haarlem suddenly came to the realisation that they did not want to be the ones holding the contract if they could not make a profit.

It began slowly, but with each passing trade, contract holders were selling their paper for less and less. The first few sellers were not too concerned by making a small loss, but steadily, each new contract holder became more anxious that they may not indeed make a profit. This cycle carried on through the night in Haarlem. Eventually, by the break of day, the price of futures contracts for tulip bulbs had collapsed by 95% of what they had started at the evening before. At daybreak, word spread across the country and soon every tulip trader was panicking to get rid of their assets. Overnight, the tulip bubble had burst, leaving the unlucky holders out of pocket and nowhere to turn – with the most unfortunate losing their life savings in the dramatic end to the Tulip Mania.

Most historians agree, the Dutch Republic of the 17th century created the foundations for modern finance. Amsterdam saw the creation of the world’s first company, the first shares, the first stock exchange, the first derivatives, and the first financial bubble. Today, almost four hundred years later, the madness of crowds persists. Looking at the US housing market bubble, as well as at the Bitcoin mania of 2017, it is clear that human behaviour – in an economic context at least – has not changed at all since the Tulip Mania of the 1600s.

This instinctive rather than rational behaviour of market participants – irrespective of their history, knowledge, context and education – to believe in the infallibility of the growth in value of markets and commodities lies at the root of the problem. In banking, this recurring compulsive human behaviour is particularly pertinent, since banks are the engine room of economic growth, and thus would ideally have greater capability in discerning risk rather than exacerbating these asset price bubbles through the granting of ever-greater leverage via credit.

It is particularly ironic that Alan Greenspan, the man who was at the helm of the largest economy in the world as Chairman of the Federal Reserve, did not stop the process of significant deregulation that he witnessed taking place in the last few years of the 20th century and the first few years of the 21st century. Bear in mind that he was regarded as the most powerful regulator in the world, if not the most powerful man in the world, whose every word was recorded and interpreted for its implied meaning. Not only did he witness and allow the deregulation of the financial markets, including the drastic deregulation of the OTC derivatives markets and the repeal of the Glass-Steagall Act, he also presided over keeping interest rates abnormally low, contributing greatly to the explosion of the subprime mortgage market in the United States.

It is chilling to think that this was the very same man who had the prescience to utter the following words in his 1996 speech, The Challenge of Central Banking in a Democratic Society: “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions? And how do we factor that assessment into monetary policy?” It is distressing that a leader and regulator of such immense regard, who gave capitalism itself both a stamp of authority and authenticity, could be prone to the same animal spirits that drove traders and merchants in the early 17th century to trade flowers for houses.

This article is from the Monocle Quarterly Journal, A Short History of Banking. Visit our "Journals" section to read the full issue.