Tuesday, July 20, 2004

Markets: Bubble Double Trouble

The oldman feels somewhat out of sorts. Of late he has been a) railing against those deluded enough to believe that poverty has disappeared when there are still kids who can't afford enough to eat b) against incompetent and richly rewarded CEO's and c) against central banking follies. This is exactly the opposite of what one might expect of the oldman's disposition. The oldman is quite happy to be a capitalist, hopes to open his own business, and his most current thinking is to change careers and get a combined MBA and nanoscale physics degree. Hopefully one day the oldman will not only be rich, but will be bloody rich like Bill Gates or Buffet. Dreaming? Perhaps. The oldman is inclined to think he has a shot if only because he's already spent his life worshipping in the temple of business and economics and getting things done - just for other people. Always turning a profit for someone else. Bout time the oldman did some stocking stuffing for himself.

This is why it pains him to act now as a apostate preaching hellfire and damnation on the mainstream economic order. Yes the oldman believes that things are about to go to hell in a hand-basket, but he's also planning on sticking out the tough times, and seeing if he can make his fortune besides.

However the oldman does not think that his statements are exaggerated. One of the classic symptoms of a true bubble is infectious and irrational exuberance. The oldman is shocked to see an example of such thinking in no other than the usually steadfast commentator, Daniel Gross who finds a way to explain that the prototypical bubble of all bubbles the Tulip-mania of Holland was somehow rational afterall.

The normally sane Dutch bourgeoisie got carried away and bid up prices of tulip bulbs spectacularly in winter 1637, only to see them crash in spring. One bulb was reportedly sold in February 1637 for 6,700 guilders, "as much as a house on Amsterdam's smartest canal, including coach and garden," and many times the 150-guilder average income. As Earl A. Thompson, an economist at the University of California at Los Angeles, and Jonathan Treussard, a graduate student at Boston University, note in a working paper, "the contract price of tulips in early February 1637 reached a level that was about 20 times higher than in both early November 1636 and early May 1637."

Sounds like a bubble. But it wasn't, asserts Thompson, who is working on a history of bubbles. Tulip-bulb investors were neither mad nor delusional in 1636 and 1637. Rather, he says, they were rationally responding, in finest efficient-market fashion, to overlooked changes in the rules of tulip investing.

As European prices for the dramatic flowers rose in the 1630s, many burgomasters—local mayors—started to invest in the bulbs. But in the fall of 1636, the European tulip market suddenly wilted because of a crisis in Germany. German nobles were big fans of tulips and had taken to planting bulbs. But in October 1636, the Germans lost a battle to the Swedes at Wittstock. Then German peasants began to revolt. The German demand for tulips sagged, and princes began digging up their own bulbs and selling them, say Thompson and Treussard.

The sudden glut caused prices to fall, and Dutch burgomasters began losing money. They were in a bind. Trade in tulip bulbs was conducted through futures contracts: Buyers agreed to pay a fixed price for tulip bulbs at some point in the future. With prices having fallen in the fall, leveraged burgomasters were tied into paying above-market prices for bulbs to be delivered in the spring.

Rather than take their lumps, these politically connected investors tried to change the market rules—and they succeeded. First, they threatened to abandon their contracts and leave planters in the lurch entirely. But ultimately, they ironed out a deal whereby the obligation to purchase bulbs at a fixed price would be suddenly converted into an opportunity to do so. In current parlance, they aimed to transform tulip-bulb futures contracts into tulip-bulb options.

Under the new deal, the investors wouldn't have to pay the high contract prices in the spring unless the future market—or spot—prices of tulip bulbs were higher. (To compensate the planters in case market prices were lower than the contract prices, the investors agreed to pay a "small fraction of the contract price" to get out of the contract, Thompson and Treussard note. Ultimately, that amounted to about 3 cents on the dollar.) On Feb. 24, 1637, the Dutch florists "announced that all futures contracts written since November 30, 1636 and up until the opening of the spring season, were to be interpreted as option contracts," Thompson and Treussard write. The action was later ratified by the Dutch legislature.

The news of these discussions began to filter out into the market in November 1636. Now, when it becomes clear that a contract is to be transformed into an option—the ability to buy something rather than the responsibility to do so—you would expect prices to rise. Why? If the investors in existing future contracts were only going to have to pay a small percentage of the contract price in the end—as was becoming apparent—then tulip planters would have to jack up contract prices significantly in order to recover sums that reflected the spot market prices. And people would be willing to pay the higher prices.

Why? In the worst-case scenario, investors would lose 3 percent of the price of the contract. In the best case, prices would rise above the strike price, and they could make an instant profit while assuming the minimal 3 percent risk.

So, the market exploded. In November 1636, when the burgomasters' plans to screw the tulip planters took effect, traders began to process the impending changes into their thinking. By late November 1636, "buyers had already begun treating the contract prices as option strike prices set at around 10 times the actual prices." As a result, "contract prices soared to reflect the expectation that the contract price was now a call-option exercise, or strike price rather than a price committed to be paid for future bulbs." By February, the price had risen 20 times. "That's what caused the tulipmania," says Thompson.

So, the swift rise in prices for contracts on tulip bulbs in late 1636 and early 1637 was less a speculative frenzy than a market rationally responding to rule changes.

If they're correct—and it'll take someone with far more economic and data-crunching expertise than Moneybox to ratify or debunk their argument—then business writers will have to delete Tulipmania from their handy-pack of bubble analogies.[emphasis added]

Bullshit. Pure and simple bullshit. The oldman will detail why. But first ask yourself a simple question. Remember what your mother used to ask you? If everyone else jumped off a bridge would you too? Well the answer clearly is that group behavior however sanctioned doesn't negate the responsibility for individual rationality. So let's expand it. If the government gave you a tax break to jump off the Brooklyn bridge, would you?

Well that sums up why the Tulip-mania wasn't rational. The Tulip-mania is not by any definition a rational market response. The rational market response to a fall in demand from the German nobles was a fall in price. That was the rational market response. However, special interests lobbied and got the Dutch government to convert futures contracts into options contracts. Well with this gross and market distorting government intervention, of course the spot price for tulips artificially exploded. If you have to support the price by changing the legal mechanisms of contracts, then that is not a rational market situation. If anything the above historical evidence shows that regulatory intervention makes it impossible for an efficient market hypothesis to hold.

The government and law cannot legislate supply and demand efficiently. Attempting to do so is what creates market distorting forces that prevent rational and efficient market pricing. However when bubbles get into full swing, people will say black is white and down is up. They will even publish papers somehow trying to convince themselves and others that you can both regulate supply and demand legislatively and succeed in attaining efficient market hypothesis situations.

Of course the modern day equivalent is our uber-low interest rates. There are many economists out there stating that it is somehow rational to pay super-high prices for property because mortgage rates are so low. It is not rational. Nonetheless people will do it. An act that is logical based upon a flawed premise is not a rational choice. However people seem to forget this most basic rule of deductive logic and syllogisms, much less the more sophisticated logical fallacies. Aristotle, where art thou?!?!

Seriously folks, a purchase made on an unrealistic expectation of future asset liquidation values is not a rational purchase. Yet, by keeping interest rates spectacularly low Greenspan has created exactly such an unrealistic forward pricing expectation. The people who made out in the tech-boom were those smart and cynical enough to buy early and then sell before the peak. True believers were just shown as suckers. Don't be a sucker for someone else's gain. Make the rational choice. Don't buy into the theory that just because everyone else is jumping off a bridge that it is rational for you to do the same.


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