Tulipomania and the dot com myth

Gerard Jackson
BrookesNews.Com
Monday 7 July 2003

Numerous commentators have compared the mania for dot.coms with tulipomania. From this they drew the conclusion that it was not only inevitable that the dot com bubble had to go the way of tulipomania but, like the latter, it has no rational explanation.

I recall that some years ago Paddy McGuinness, a well-known economic commentator in Australia, claimed that economics could not explain the tulip bubble that exploded in Holland in 1636. This left me think that he had completely given up on the on the so-called business cycle, assuming he had given it any serious thought in the first place. Roger Franklin of Business Week is another commentator who cannot connect the economic dots (Like tulips, greed springs anew, May 11, 2003)

Its true, of course, that economics cannot explain psychological impulses, but it sure can explain economic bubbles. (Reading Australian economic commentators sometimes makes me think they're living in an intellectual bubble). And there is no better place to start than with the mania for tulips that began to sweep Holland in the early 1660s only to crash in 1636. The most famous description of this event was given by Charles Mackay in his book Extraordinary Popular Delusions and the Madness of Crowds (first publish in 1848 and recently republished, and still well worth reading).

Mackay's approach was descriptive, providing a case study of human folly rather than an explanation for human action. Our approach will be from the economic angle, starting with shared features. It's obvious that in both cases values were highly inflated, bearing no relation with economic conditions. But this is what always happens in booms. It happened in Britain when canal mania swept the investing class from 1792-93. Then there was the early 1820s railway mania that peaked in 1826, followed by the early 1840s railway that peaked in 1847.

Of course critics will argue that like is not being compared with like. That the canal and railway manias are understandable in that these were new investments whose potential returns had been greatly inflated by wild optimism. This kind of thing is bound to happen, so it is asserted, when new technologies emerge or when new investments appear to hold enormous promise. On the other hand, tulipomania was totally irrational, almost a madness that did not involve genuine investment. Therefore the similarities are superficial.

What one should note about this argument is its superficiality. It does not refute, it merely rejects. Returning to similarities we find that speculative manias (and that's what they are) always show the same symptoms, strongly suggesting that there is a single cause, regardless of whether the subject of speculation is a flower, railways or dot.coms. As the price of the asset(s) rise more and more investors are attracted to it by the prospect of easy capital gains, thus bidding the price ever higher which in turn, etc.

The point is finally reached where a speculative frenzy emerges and assets are bid up to ridiculous and unsustainable levels in a lemming like urge that casts aside all common sense. The final stage arrives when people panic and abandon the asset, taking what they can, which usually amounts to large losses. The winners, as always, are those who, for whatever reason got out first.

The Austrian explanation is deceptively simple and can be traced back to David Ricardo and is summed by the term credit expansion. And that goes for tulipomania. It was not a national and irrational passion for tulips per se that caused the boom, therefore, but credit expansion. I concluded that credit expansion was the culprit because transaction levels were maintained throughout the rest of economy. There is no way this could have happened without a monetary expansion.

In his recent book, Tulipomania, Mike Dash reveals that the volume of trading around promises to buy and sell during the mania "was not less than 40 million guilders" while the Dutch banking system only contained deposits of 3.5 million guilders. Credit and paper fuelled the frenzy and carried it to unforgettable heights of human folly and greed. (The same thing happened with the South Sea Bubble in 1720).

Dash concluded that the boom did little damage to the Dutch economy. Probably true but dangerous because one could have concluded from this observation that the dot.com boom would not damage the American economy. Let me make this clear. It is not the boom, which is only a symptom, that causes the damage but the credit expansion.

Tulipomania would have done little damage to the Dutch economy because it was still largely agricultural. Once an economy starts to industrialise the damage can become immense. Credit expansion misdirects production, and where the stages of production are enormously developed and complex the greater will be the distortions.

Once again, our commentators have made the mistake of confusing symptoms with causes. I think it's time that the McGuinness' and the Franklins started to do a little homework.

Gerard Jackson is Brookes' Economics Editor