Crash - A Brief History of Economics

The Universe in a Tulip Bulb

It was glorious: you took what you had saved up for a down payment on a house and invested it, and in a little while you had enough to buy a house. In cold hard cash. Making money had never been easier. Everybody wanted a piece of the action. People even quit their jobs to do nothing but speculate on the financial market. And it worked.

Sound like something you're familiar with? But we're talking about a different market here: the buying and selling of tulips, a business that 'blossomed' in Holland in the seventeenth century. Europe's well-to-do took a liking to these flowers as soon as they arrived from Turkey. And the Dutch, who knew how to make money just as well as they did windmills, started planting loads of bulbs to supply the buyers.

Then something unforeseen crept into the story: a virus. When this bug contaminated a tulip, it weakened the flower and damaged its pigment. Awful for the plant, great for humans, since the injury enhanced the flower's beauty, leaving it streaked with milky white veins. The virus only attacked once in a while, however, making this variety rare and unique. So unique that it earned an ostentatious name – Semper Augustus – and an obscene price. In 1624, in Dutch florins, one bud cost as much as a house in Amsterdam – or to couch it in terms of today's ostentatious names and obscene prices, it would have been worth as much as a Cartier Submariner Rolex: $100,000.

Soon Semper Augustus was no longer just a luxury but nothing but a luxury. Its steep price pushed up the quotations on other tulips – the mere existence of a $100,000 Rolex makes a $10,000 one seem cheap, right? So the same thing happened with regular tulips. Just being a tulip was good enough; there were plenty of people eager to pay top florin for any variety.

Florists would only do business in the spring, when the bulbs were flowering. But as prices began rising, this practice quit making sense. If you were a florist and needed money in the middle of the winter – months before you could sell your plants – you'd have no trouble raising capital: all you had to do was sell the bulb itself, without the flower, and let the customer wait for the tulip to appear.

Thus a new market was born. Speculators began buying heaps of bulbs in hopes of reselling them at a higher price when the flowers showed their faces. You've got to admit, it was a very shrewd investment since prices wouldn't quit climbing. The speculators didn't even have to actually take the bulbs home. They simply kept a contract (a "note," in financial jargon) that ensured their right to the money that the flower would later earn.

It wasn't long before the contracts themselves were being traded. Someone who had paid 1,200 florins for one of these notes in hopes that the price of the bulb would go up in the spring would sometimes prefer to sell to someone else for 1,300 florins and pocket the profit right away, rather than waiting. This someone else might then find another someone else willing to pay 1,400 florins and so would sell off the note, taking home an easy 100-florin profit. It was such a sure thing that the more cunning started to engage in a bit of financial juggling. They'd borrow, say, 1,400 florins to buy a bulb and then sell it later the same day for 1,500. This goes beyond easy money. It's profit without any investment whatsoever – something speculators call "leveraging." Any old Dutchman who woke up without a penny to his name could take out a loan in the morning, buy a tulip at noon, sell it for more in the afternoon, pay off what he owed plus interest, and go to sleep having turned a nice profit.

You could even make a living that way. And still can. In fact, that's how banks make money even today. They borrow at least three times what they have and invest it. Then they pay it all back and hit the sack having made a profit. Lehman Brothers, the biggest U.S. investment bank until 2008, borrowed up to $30 billion for every $1 billion it had in hand. It's like someone who has an income of $30,000 borrowing a million every year. Paying all this off and going to bed richer isn't for everyone – not even for Lehman, which collapsed, dragging the world economy down with it. But that's a story for chapter 13.