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Subprime AND

Tulip Mania
After 400 Years, Are We Making the Same Mistakes?

Hyoung, K. J.; Karim, A; MacGregor, S. C.: Pan, X; 2010

Early in the European winter of 1636, a rare Violetten Admirael van Enkhuizen tulip bulb
sold for 5,200 Dutch guilders1, a sum which would have purchased a modest home in a
glamorous canal-side area of Amsterdam. In 2005, the repayments on a mortgage for a
three bedroom fully detached home in suburban Phoenix, Arizona would amount to
roughly 180% of that of the equivalent rental payments one would make on the very same
house2. Neither of these seem intuitively logical, and represent poor economic choices;
but did the financial forces which made for one, make for the other?

What we are analyzing are two asset bubbles. These are rare circumstances in which a
large volume of reasonably homogenous value-bearing goods are traded for well above
their intrinsic value. There are several consistencies between the Tulip Market of early
1630s Holland and the subprime mortgage market of the first decade of the 2000s in the
United States, and we shall explore each.

Animal Spirits

Animal Spirits is used to describe the irrational motivations and behavior of humans,
which is the most basic factor that leads to both Tulip mania and Subprime mania. John
Maynard Keynes (1936) stated animal spirits in terms of confidence, fairness, corruption,
storytelling, and money illusion.

Firstly, over-confidence was the first most decisive instinct displayed. Both in Tulip mania
and in Subprime mania, people were over-confident that asset prices would continue to
rise. Investors did not care about what the tulip was or what a reasonable house price
should be or the intrinsic value of either, but only about using these products to make
more and more short-term capital gains without due regard for long-term income potential
and thus intrinsic value.

Secondly, People may be influenced not only by economic value but also by psychological
factors. With the increase of tulip market demand and price where more and more people
thought it was worth investing in them. Similarly many poorer Americans believed that
owning a house was better than renting one although they were unable to pay the
mortgage. In such an overheated atmosphere, mortgage lenders loosened their lending
standards to accommodate investors with such high expectations and confidence of future

Easy Money

For Tulip mania, everything might have started with debased currency due to new money
system. One of the first measures instigated devaluation of currency was free or individual
coinage. The state offered to mint coins out of any quantity of metal delivered to it,
either making no charge or a very small charge to cover cost.

Secondly, Appearance of Bank of Amsterdam induced depreciation rate of coin below its
nominal or face value. In 1609, the bank of Amsterdam was initially established and
accepted coins and gave credit to the depositors based not on the face value of the coins
but on the metal weight or intrinsic value of the coins. Therefore, depositors were given a
premium on inferior sort of money. Generally, the premium represented the depreciation
rate of the coin. The combination of these two factors caused a huge increase in the
money supply in Holland.

A similar thing occurred in the US. The US Federal Reserve Bank lowered the interest rate
sharply (in response to the 2001 recession) to 1% by 2003. In an economic sense, low
target interest rates cause increases in the money supply. Prolonged low interest rates and
influx of foreign funds (because of easy credit conditions) fueled a housing market boom
and it also encouraged debt-financed consumption on home ownership.

As a result, the USA home ownership rate increased up to an all-time high of 69.2% by
2004. Between 2001 and 2006, the price of the typical American house increased by
approximately 124%.

In both cases, we can find the common factor of massive increases in money supply. It was
induced by different method; however, the result was the same.

Financial Innovation

In 1630s Holland, strong demand for certain rare tulips had caused prices to increase
sharply. As the tulip prices continued to rise significantly, more and more people got
attracted to make gain from the increasing prices. Limitation in trading tulips at that time
was that tulips were only harvested in certain season, particularly not in winter. To
secure the profit, in around 1634, the practice of buying tulips for future delivery became
acceptable. As such tulips were effectively traded using futures contracts. With the
increasing demand for rare tulips, in 1636, tulips were began traded on the Amsterdam
Stock Exchange in 1636.

The emergences of future contracts encouraged the speculation in tulips even further.
This time, neither the buyer nor the seller intended the actual delivery of tulips at the
settlement date. Rather, they only wanted to bet on the tulip prices. The contracts would
only settle in cash. This speculation drove tulip prices even higher until the bubble burst
and people began defaulting on their contracts. Eventually, panics spread and the prices
of the tulips dropped to the level of only a small fraction from their peaks.
Relaxed lending standards for mortgage borrowers during the housing market boom in the
U.S. between 2000 and 2005 attracted subprime borrowers to enter into mortgage
contracts. Following the originate-to-distribute model widely used by banks at that
time, those subprime mortgages were, in turn, repackaged and securitised by the
mortgage originators into Mortgage Backed Securities (MBS) which were then sold to
investors including investment banks.

Investment banks with their creativity bundled and repackaged those MBS into
Collateralised Debt Obligations (CDOs) and sold them on. By doing this, investment banks
were able to get more credit from investors and increased their leverage.

Lax Regulation

In the 1630s, as some of the first derivative instruments were traded on the Amsterdam
stock exchange (tulip futures), the Dutch Parliament gave little consideration to the need
to regulate the market or curtail the wild speculation and agency problems which arose at
the time.

In 1999, after The Republican Party had been elected to the US house of representatives
the previous year, their first order of business was cutting red tape and shinking
government down to a size so small that it can be drowned in a bathtub, the legislature
passed the Gramm-Leachy-Bliley Act, which repealed the provisions of the Glass-Steagall
act, a New Deal era regulation which kept retail banking separate from Investment

This allowed retail banks, such as Washington Mutual, to exit longer term, income-driven
investments and enter what was increasingly becoming a casino of short term capital gain
speculation in trading martgage backed securities, CDOs and other exotic instruments
which lacked historical price data and adequate methods of pricing.


The four areas we have explored have lead us to an inevitable conclusion. Both in 2000s
United States and 1630s Holland, an unregulated, animal-spirited market, with new found
liquidity and exotic new instruments, poured resources into poor investment avenues,
planting the seeds (or bulbs) of the bust that would surely follow. After 400 years, we are
indeed making the same mistakes.

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No. 1 (spring 2006)

Bernanke, B; Keynote Speech to the Annual Meeting of the American Economic

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Dash, M; 2000; When the Tulip Bubble Burst: TULIPOMANIA - The Story of the World's
Most Coveted Flower; Crown Publishers

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