Every once in a while someone is impelled to try to claim that one or the other of the more notorious bubbles in history was in fact not a bubble--that the market was in fact functioning efficiently, that asset prices were equal to fundamentals, that traders were behaving rationally given the information they had, and behaving rationally in their decisions to spend resources acquiring information, so that buyers and sellers were making investments that were good and appropriate from a rational ex ante perspective.
There is a problem with this enterprise.
Efficient markets are those in which prices move far and fast only when fundamentals change a lot. And fundamentals change a lot only when a lot of information--information that changes rational assessments of fundamentals--arrives in a very short time. With respect to the seventeenth-century rare tulip market, the fundamentals are the patterns made by the tobacco mosaic virus on infected tulips, human aesthetic preferences, and the biology of tulip reproduction. Those are not fundamentals about which much information can arrive quickly.
Without any such information arrival, attempts to claim that the tulipmania bubble and its collapse was a rational event are not, themselves, examples of human rationality…
C.W. and A.J.K.D. write: Economic history: Was Tulipmania irrational?:
IN THE 1630s… a… Semper Augustus… just before the crash… was valued at… the cost of luxurious house in Amsterdam. Prices collapsed in February 1637…. The price swings were not caused by massive changes to production costs. Nor did tulips suddenly become particularly useful. As a result, most people assume that tulipmania was the result of financial market irrationality…. But economic historians provide better explanations…. Peter Garber… reckons… bubonic plague… made people less risk-averse…. Because gambling was illegal… traders [who] misjudged the market… could just run off without paying…. According to Nicolaas Posthumus… serious tulip financiers generally did not participate… “mania” 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…
In reverse order, the argument here is that financial markets and traders were all perfectly, perfectly rational, and the market was perfectly, perfectly efficient, except for:
- Serious tulip financiers and traders--but "only in the month before the crash".
- Non-serious "casual" traders--but only because they were "drunk on jenever and moral hazard".
- Those who sold tulip contracts because the fact that buyers had the option to run off without paying placed sellers on the wrong side of a one-way bet
- Those who bought because they feared that they were about to die of bubonic plague--for the argument that it was rational for them to decide to spend the price of a house on a Semper Augustus tulip bulb that they would never see blossom because they would be dead does not pass the laugh test. I mean, a rational fearer of bubonic plague would leave town or hold a party, not buy a tulip bulb for more than its fundamental value.
Thus the statement that "the Tulipmania was rational" seems to bear a close resemblance to the statement that "Mary Todd Lincoln enjoyed her evening at Ford's Theater". I mean, by the time one has added up the trades and the impact on prices of all those who traded while drunk, all those who traded while gambling with other people's money, serious traders in the last month before the crash, sellers who did not understand the potential for moral hazard, and those crazed by fear of the bubonic plague, we have a market that is functioning in a way very different from that envisioned by Fama and Merton, no?
C.W. and A.J.K.D. continue by citing Earl Thompson:
Earl Thompson… reckons that the market for tulips was an efficient response to changing financial regulation… the anticipated government conversion of futures contracts into options contracts…. 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…. 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…
One again, Alas!
I lost my confidence in Thompson when he wrote:
Up through the summer of 1636 it looked as though the [Thirty Years'] War was winding down…. Although France… had entered… in mid-1635, their early defeats in central France made it appear that the [Thirty Years'] War was basically over. It should therefore be no surprise that tulip prices were generally rising at an abnormally high rate… increasingly so up to the fall of 1636…
From the perspective of the Netherlands, it is not the Thirty Years' War 1618-1648--that is the German perspective.
From the perspective of the Netherlands, it is the Eighty Years' War 1568-1648, interrupted by a Twelve Years' Truce 1609-1621, and resumed in 1621. Fortunately for the Netherlands, their Spanish-Imperial Habsburg adversaries who wanted to reassert Habsburg right to rule the Netherlands as Duke of Holland, etc., got distracted by the Thirty Years' War with its Bohemian, Palatinate, Danish, and Swedish phases. A winding-down of the Thirty Years' War would not mean peace and prosperity for the Netherlands: the Habsburg armies would not go home but, rather, converge on the Netherlands, which would not be good for the tulip markets of Amsterdam and Haarlem. To say that a winding-down of the Thirty Years' War in 1636 was good for tulip prices is to misread the political-military situation to an astonishing degree.
And, of course, the Thirty Years' War was not winding down in 1636. France had just entered the war.
But getting the fundamentals about the Thirty Years' War wrong is not the only problem I see with Thompson.
Thompson sees the big price movements as efficient responses to rational forecasts of changes in regulation. He thus attributes rises in futures prices starting in November 1636 to the conversion of futures contracts into options at the end of February 1637. But the contractual transformation to be made three months in the future affected only contracts entered into after November 30, 1636--leaving the November purchasers high, dry, and broke. To bet that the tulip-sellers are wrong in the belief that contracts mean what they say--and then to be wrong in your bet--is not how an efficient market moves
Thompson's explanation for the rise in prices in 1636?
- That the sellers proved politically more powerful than expected.
- That innocent buyers in November 1636 had acted in reliance on the belief that all contracts entered into after mid-October would be transformed from futures contracts into options contracts.
- That such buyers "were the real victims… because they thought they were buying an option but were forced to pay the falsely-assumed exercise price out as a futures prices because the contractual conversion was delayed a month beyond the… previously-announced date."
Thompson characterizes the tulip market as "impressively price-efficient [and] fundamentally-driven".
But Thompson also characterizes the market as one in which sellers think they are selling a futures contract and buyers think they are buying a call option--and in which buyers then turn out to be wrong for November, and then wrong again about what the price of the call option was to be (was it to be 0% of the exercise price, 3.5% of the exercise price, or was it 10%?)
I am sorry, but such a market is not "impressively price-efficient [and] fundamentally-driven".
For a market to be efficient, there has to be agreement first of all on what the commodity being sold is and on what quoted prices mean before you can even begin to talk about market efficiency and rationality. Rational traders do not buy financial securities just because the seller whispers to them "I know the contract says that this is a futures, but I happen to know that it is going to be transformed into a call option, so pay no attention to what the piece of paper says--I'm really offering you a very good deal". And when there is uncertainty, a rational market does not respond with volatility. Rational markets are volatile not when situations become uncertain--then their prices hug the prior mean. Rational markets exhibit volatility when uncertainty is resolved.
And there is even a deeper problem with Thompson: Thompson says it was rational to offer to pay the price of an Amsterdam house for a Semper Augustus tulip bulb in January 1637 because you were really merely paying 0% (or 3.5%, or 10%--nobody knew how much) for a call option on a Semper Augustus tulip bulb with a strike price of an Amsterdam House because you anticipated the legal shift of February 24, 1637. Doesn't it, then, make sense after February 24 to offer the same amount to buy what is then explicitly the call option? But we don't see any such contracts traded after the crash, even though the legal security of buyers' claims that the contract is a call and not a future is much, much stronger after February than before.
Some facts remain clear:
- There were no items of significant news about fundamental tulip values between September 1636 and March 1637.
- There were no items of significant news about the variance of the distribution of fundamental tulip values between September 1636 and March 1637.
- In efficient markets with rational traders, big price moves in the underlying come only with big pieces of fundamental news.
- In efficient markets with rational traders, big price moves in options come only with big pieces of news about the volatility of fundamentals.
To claim that the tulip market between September 1636 and March 1637 was not a bubble-and-crash--that the market was "impressively price-efficient [and] fundamentally-driven"--is itself yet another striking example of extraordinary popular delusions, and the madness of crowds.