What happens when bubbles burst?

What happens when bubbles burst? Who experiences the most financial losses, and how does it affect the economy?

tulip-Frenzy

I was reading about the famous Tulip mania of the Netherlands in the 1630s. Firstly, some of the stories may have been slightly exaggerated, but there was no doubt that small tulip bulbs vastly increased in price due to a speculative boom. It was said in 1634, some tulip bulbs were trading hands for ten times the annual salary of a skilled worker.

Normally conservative people were encouraged to jump on the bandwagon and buy tulip bulbs as their value rocketed. It seemed an easy way to make capital gains.

The bulbs became so valuable no one dared even to plant them, but instead were left on display around the house. One apocryphal story tells how a visitor mistook a very expensive bulb for an onion and ate it for breakfast. It’s a great story, though you’d have to be pretty limited senses to think a tulip bulb was an onion.

As the mania reached its peak, people were borrowing on credit and buying promissory notes. Bulbs were no longer changing hands, just contracts that you owned a bulb. People didn’t even stump up the cash, but would just pay a deposit, expecting to pay for the bulb by selling after it had risen in price. It was a forerunner of today’s future contracts.

It all sounds eerily familiar to the sub-prime crisis nearly 400 years later. Except in the modern time, it was credit default swaps for mortgage loans rather than tulip bulbs.

But, what happened when the tulip bulb price collapsed?

The evidence is somewhat limited. Many people certainly lost a lot of money. Those who had borrowed to buy tulip contracts now found that they had lost their life savings and many were heavily indebted because they hadn’t finished paying for the tulip bulbs which had now collapsed in price.

But, the interesting thing is that the economy was perhaps not as badly affected as we might have expected. There was just a general acceptance that tulip contracts were worthless and ignored. Judges ruled that tulip contracts were effectively debts as contracted through gambling and so were not enforceable. So although many people had lost out, that contracts just weren’t enforced. People who had, on paper, lost a fortune found their contracts couldn’t be enforced, so it wasn’t quite as bad as it could have been.

The impact on the economy

The impact of the tulip mania burst on the Dutch economy is harder to know. Some historians have suggested that the Netherlands economy experienced decades of economic hardship in the aftermath – though this may have been a reflection of other factors like simmering wars and bad weather. Other historians believe the tulip crisis had little bearing on the economic welfare of the economy. It is hard to have any certainty. Certainly, the shock of losing fortunes would have made people more risk-averse and likely encouraged more conservative approaches to business. But, it was not perhaps the devastating blow, we might first have thought of.

 

When other bubbles burst

  • South Sea bubble 1720s – large impact on the economy. Led to recession due to the scale of financial losses. Also led to changes in the law about ownership of shares and companies
  • Railways mania 1840s – many middle-class investors lost a fortune when railway share prices fell, contributing to an economic downturn. At least the economy did get quite a few good railway lines out of the period.

stock-price-cape

  • Stock Market crash 1929 – Perhaps the most damaging bubble bursting. When US share prices fell in 1929, it precipitated the great depression of the 1930s. The stock market crash wasn’t by any means the only cause of the great depression, but it was an important factor.
  • Stock market crash 1987. A 25% crash in share prices which had little if any adverse impact on the economy. The stock market soon recovered.
  • The Dot Com bubble 1999. A crash in technology share prices from unsustainable levels. There was a fear this would cause a recession, but a loosening of monetary policy prevented it.

us-house-prices

  • The housing bubble and bust of 2000-2006. When US house prices fell in 2006, it caused a widespread financial disaster because of the way the housing bubble had been financed.
  • Credit bubble and credit crunch of 2000-2008. The credit crunch of 2007-08 caused one of the deepest recessions of the past 100 years and widespread financial turmoil. It could have been much worse without government bailouts. But, so far there has only been a very limited change in the way financial markets are regulated.

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By on September 27th, 2017

2 thoughts on “What happens when bubbles burst?

  1. Nice summary. Thank-you.

    Is it then too much to suggest that the ‘globalization’ of economies in our ‘Age of the Computer’ has made crashes much more systemically worse. Economic crashes are now not as ‘localised’ and therefore consequences are much more difficult to then deal with?

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