Classic Bubbles

1. Classic Bubbles Fin254f: Spring 2010 Lecture notes 2.1

2. Three Classic Bubbles • Tulips (Holland, 1634-37) • Mississippi Bubble (France, 1719-20) • South Sea (UK, 1720)

3. Tulip Bubble in Economic Lore • Key story of irrational speculation • Indicative of completely crazy pricing • “Tulipmania” • “X” just like tulips • Garber is not so sure on this

4. Tulip History • Holland 1593-1637 • Tulips infected with virus • Causes spectacular colors in infected tulips • Cannot be propagated through seeds • Only from buds of mother bulb (limited supply: 1-2 per bulb) • Weakens bulbs too • Relatively rare

5. Bulb Markets: 1634-37 • Before 1634: Professional growers only • Flowers cultivated in June • Markets from September - June are futures markets • Delivery in June • Most formal markets 1636-37 • Often meet in taverns

6. Futures Nature of Trading • Purchase contract for later delivery (June) • Some uncertainty as to the exact structure • Small initial amount down (about 1/40 contract price) • Make or lose depending on eventual spot • Differences from futures • No margins: positions can be very large • No marking to market

7. Two Markets • Very rare bulbs • Serious/informed traders • Markets go for entire period • Often just spot (not futures) • More common bulbs • Start in late (November) 1636 • Traded by a wide range of people

8. Rare Bulb Example:Admiral van der Eyck • Guilders/aas(1/20 gram) • 1634: 1.5 • July 1636: 2 • Feb 1637: 4.25

9. Common BulbOudenaerden • Nov 1636: 0.075 • Dec 1636: 0.080 • Jan 19, 1637: 0.30 • Jan 31, 1637: 0.50 • Feb, 1637, max = 0.8, avg = 0.5

10. The Crash • First week of Feb, 1637 • Bulb trading ends • Markets formally shut down in April • Prices hard to find

11. Some Price Falls • Witte Croonen (Guilders/1/2 lb.) • Jan 1637: 64 • Feb 5, 1637: 1668 • 1642 or 1643: 37.5 • Depreciation 76% • General Rotgans (Guilders / bulb) • Feb 1637: 805 • 1642 or 43: 138 • Depreciation 35%

12. Later Data • Rare bulb cycles • Garber finds that 20-30 percent depreciations are common for very rare bulbs

13. Economic Impact • Rare bulb price increases had little impact on general agriculture • Common bulb increases occurred after planting (Sept 1636) • Did Holland go into recession?

14. Key Points • Futures and credits • Final (last month) frenzy • Technological foundations • Heterogeneous markets • Informed/rare: less bubble like • Uninformed/common: more bubble like • Was there a bubble?

15. 2. South Sea Bubble • Stock market event of 1720 • Sister bubble in Mississippi company • Both show big run ups in stock price and eventual crashes

16. Technology Changes • South Sea and Mississippi both issue shares in exchange for government debt (UK and France) • Set to exploit trade with Americas • Spanish withdrawing • First publicly traded insurance companies appear

17. South Sea Share Prices • UK pounds 1720 • Jan 1: 150 • April 10: 300 • July 20: 1000 • Nov 1: 150

18. Margin Buying • Investors able to buy on 10 percent margin in most of this period

19. IPO Bubble Starts • Lots of great stories • Crazy companies: Sunlight from cucumbers • “A company for carrying on an undertaking of great advantage, but nobody to know what it is”

20. Bubble Act • June 1720: Parliament passes “bubble act” • New firms need to be approved by parliament • Tries to stop new fraudulent companies • Enforced at end of August 1720 • Downward pressure on new companies • Unwinding margin buyers drives liquidity scramble • South Sea company falls too

21. Frehen et al.New Evidence on the First Financial Bubble • Break down stock price movements • Different firms, and different information • Were speculators indiscriminant or, • Were they following some economic logic?

22. Cross Section in London Stock Exchange • South Sea increases about 10x • Two others increase more • London assurance 50x • Royal exchange assurance 11x • East India Company • Involved in South Asia trade • Increases 3.5x

23. Dutch Shares • Dutch East Indies company • Moderate increase (10 percent) • Dutch West Indies company • Increases by 10x • Investors again value Atlantic trade • Similar patterns to London market • Economic causes, financial integration(timing) • If bubble then not local

24. Timing • Some evidence for spillover from Britain to Holland • Bubbles seem to move ahead in Britain

25. Cause of the Crash • Bubble act • Insurance problems • Loss of fleet of 12 ships off Jamaica • Burglary of a director’s house

26. More on Dutch Firms • Dutch firms did not purchase government debt • That could not be the cause for their price rise • Suggest it might not have that much to do with either the South Sea or Mississippi bubbles either

27. Final Returns over 1720 • Three Atlantic trading firms do well • South Sea (up 45%) • Royal Africa (up 91%) • West Indies Company (up 51%)

28. Economic Impact • Big negative hit on insurance underwriting

29. Fun Quote: Sir Isaac Newton • Newton was one of the losers in the South Sea Bubble • “I have learned to predict the movement of celestial bodies but not the movement of man in markets.”

30. Early Bubbles: Summary • Large increases and crashes in prices • Expansion of credit • Some “logic” to beliefs • Sensible beginnings • Total craziness at the end (uninformed speculation) • Economic impact??