What causes economic bubbles Prateek Singh
How much would you pay
for a bouquet of tulips?
A few dollars? A hundred dollars?
How about a million dollars?
Probably not.
Well, how much would you
pay for this house,
or partial ownership of a website
that sells pet supplies?
At different points in time,
tulips, real estate and stock in pets.com
have all sold for much more
than they were worth.
In each instance, the price rose and rose
and then abruptly plummeted.
Economists call this a bubble.
So what is exactly is going on
with a bubble?
Well, let’s start with the tulips
to get a better idea.
The 17th century saw the Netherlands
enter the Dutch golden age.
By the 1630s, Amsterdam was an important
port and commercial center.
Dutch ships imported spices
from Asia in huge quantities
to earn profits in Europe.
So Amsterdam was brimming with wealthy,
skilled merchants and traders
who displayed their prosperity
by living in mansions
surrounded by flower gardens.
And there was one flower
in particularly high demand:
the tulip.
The tulip was brought
to Europe on trading vessels
that sailed from the East.
Because of this, it was considered
an exotic flower
that was also difficult to grow,
since it could take years
for a single tulip to bloom.
During the 1630s, an outbreak
of tulip breaking virus
made select flowers even more beautiful
by lining petals with multicolor,
flame-like streaks.
A tulip like this was scarcer
than a normal tulip
and as a result, prices for these flowers
started to rise,
and with them, the tulip’s popularity.
It wasn’t long before the tulip
became a nationwide sensation
and tulip mania was born.
A mania occurs when there is an upward
movement of price
combined with a willingness
to pay large sums of money
for something valued much lower
in intrinsic value.
A recent example of this
is the dot-com mania of the 1990s.
Stocks in new, exciting websites
were like the tulips of the 17th century.
Everybody wanted some.
The more people who wanted the tulip,
the higher the price could go.
At one point, a single tulip bulb
sold for more than ten times
the annual salary of a skilled craftsman.
In the stock market,
the price of stock is based on the supply
and demand of investors.
Stock prices tend to rise
when it seems like a company
will earn more in the future.
Investors might then buy more
of the stock,
raising the prices even further
due to an increased demand.
This can result in a feedback loop
where investors get caught up in the hype
and ultimately drive prices
far above intrinsic value,
creating a bubble.
All that is needed for a mania to end
and for a bubble to burst
is the collective realization
that the price of the stock,
or a tulip,
far exceeds its worth.
That’s what happened with both manias.
Suddenly the demand ended.
Prices were pushed to staggering lows,
and pop!
The bubbles burst, and the market crashed.
Today, scholars work long and hard
trying to predict what causes a bubble
and how to avoid them.
Tulip mania is an effective illustration
of the underlying principles
at work in a bubble
and can help us understand
more recent examples
like the real estate bubble
of the late 2000s.
The economy will continue
to go through phases
of booms and busts.
So while we wait
for the next mania to start,
and the next bubble to burst,
treat yourself to a bouquet of tulips
and enjoy the fact that you didn’t have
to pay an arm and a leg for them.