Saturday, August 20, 2011

Boombustology: Chapter 6

Asset bubbles are frequently popping up, and back down. They are easy to spot in hindsight, but we appear to lack the tools to recognize them ahead of time. Vikram Mansharamani aims to rectify that with his book, Boombustology. He applies a multi-lens approach to understanding bubbles with the aim of giving the reader the ability to identify bubbles, and thereby avoid being caught unaware.

No part of the world has proven itself immune to bubbles. Each of the next few chapters examines a bubble from the point of view of the five lenses described in the first five chapters.

The topic of this chapter is Tulipmania, a bubble for tulip bulbs that took place in Holland in the 1630's. Some background is in order so that the context is understood. Holland had just gained independence from Spain through war, and was intercepting some Spanish ships carrying goods from the West Indies. The country found itself newly prosperous as an innovative, trade-friendly country. At the same time, however, scores of its population were dying as a result of bubonic plague.

Tulips were a relatively newly discovered type of flower (brought over from the Mediterranean) with colour schemes that had not yet been seen before. Many bulbs carried unique patterns, and offspring could not be grown quickly. Because bulbs had to be in the ground most of the year, they could only be exchanged in May and October, so futures contracts were created to facilitate sales that did not take place in those months. At one point during the bubble, many elites (including politicians) lost money when prices retreated. As such, the laws were changed so that futures contracts became options contracts, whereby the buyer would get to choose whether to take delivery of the bulbs when the time came to exchange.

Here is how the bubble may be viewed through the five lenses described in the previous five chapters:

1) Microeconomic: Many buyers were hoarding bulbs, signaling a breakdown of equilibrium pricing. Price was affecting, rather than reflecting demand.

2) Macroeconomic: Due to the capital inflows through successful trade and seizure of Spanish ships, there was a dramatic increase in the money supply in Holland. Easy money was undoubtedly making its way into this bubble.

3) Psychology: The massive deaths caused by the plague were giving citizens a short-term mentality. Since death might be near, thoughts of long-term repercussions to actions were at a low.

4) Regulatory: Because futures contracts were changed to options contracts, highly levered speculation ensued. People could buy the upside of bulbs without much downside, resulting in asymmetric risks. Shortly after the regulation was switched back, prices plummeted.

5) Biological: Citizens in all fields took part, from nobles to chimney sweeps. From the epidemic model, we know that this leaves very few people to be "infected", resulting in an eventual pop.

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