If you are interested in cryptocurrencies such as bitcoin, chances are that you have heard some skeptic make a comparison with ‘tulips’. Why would blockchain-based assets be compared with that particular flower? Well, it is all to do with one of the craziest bubbles ever inflated, which was what I want to talk about in this post. In order to lay down the groundwork, though, we have to go way back in time to the 15th century…
In The Beginning…
The story of how Amsterdam’s most famous bloom became the basis of one of the most infamous speculative bubbles does not actually begin in the Netherlands, but rather in Spain and Portugal. The end of the 15th century saw improvements to the design of ships and inventions that were to prove important for navigation, such as the clock and the compass. Together, these advances made it possible to cross oceans, discover new lands, and open up trade routes.
The Christian kingdoms of Spain and Portugal did just that, famously sending Christopher Columbus west in 1492 on a journey that would ‘discover’ the Americas. Five years later Vasco de Gama journeyed southward to discover the Cape Of Good Hope and the naval route to India.
With these discoveries, both Spain and Portugal suddenly found themselves with trading options along African and Asian coasts, not to mention access to vast and rich territories in the New World. This meant that, from the 16th century onwards, the scene was set for a transformation from the old feudal economies to mercantile economies. The international trade routes made it possible to create far superior wealth compared to that offered by grain production by the small feudal fiefs of Europe. Mercantile economies were based on the idea that a country’s total amount of wealth represented the overall profit it made from trade. As each strip of land obviously holds only a limited amount of tradable resources, the volume of a country’s trade was dependent on the amount of land over which it held trade rights.
Mercantilism therefore lead to expansionism, as any European power that could afford it sent off ships in search of hitherto undiscovered territory (not discovered by any other European, that is). It was customary for the Monarch to hold claim to the new territory overseas, the management of which required a large administrative body under direct royal control. It had always been profitable to serve the King during times of war, but the territorial expansion meant the nobility could make more wealth serving the King abroad rather than by managing their private estates.
This lead to a powerful, centralised monarchy and the creation of the first great European empire. But there was something of a downside to this way of organising things, since the creation of a powerful, centralised monarchy held back the creation of a strong and independent mercantile class, which in turn held back private enterprise. The result of all this was that capitalism did not grow out of the empires of Spain and Portugal, but rather from one of the more disadvantaged newcomers in the race for international trade.
The Dutch East India Company
That nation was the Netherlands. The end of their 80-year struggle for independence from Spain left the nation with no significant aristocracy and not much in the way of marked class differences. Instead, the Netherlands developed a significant middle class that thrived on trade. Up to the Industrial Revolution, Amsterdam could lay claim to being the greatest city in Europe, as well as laying claim to a few ‘firsts’ in capitalism. For example, many historians consider the Netherlands to be the world’s first truly capitalist nation. Also, the Dutch East India Company, which was formed in 1602, was one of the first multinational companies. Also, by being the first company ever to offer its stock on the market, the Dutch East India Company pretty much invented the stock market, meaning the Dutch could claim that among their list of ‘firsts’ too.
The Netherlands were really successful at trade, so much so that it had managed to drive the Portuguese off most of their trading posts in the Indian Ocean. By the 1630s, the timing was almost right for a period of mass speculation. Thanks to the trade of their merchants, the Dutch were the recipients of the highest salaries of any European. Shares of the Dutch East India Company were richly rewarding shareholders for their investments, and much of that money was being poured into properties to create a robust housing market. Ongoing appreciation of asset values created excess wealth that went on to fund further asset purchases.
This wealth was setting the scene for an asset bubble, but at the time there was something holding back the move toward wild speculation. That something was the fact that not everyone could take part. This was because Dutch East India shares were both expensive and illiquid (in other words not easily resold) and that made them unavailable to all but the wealthiest. The same could be said for the most prized properties. However, a quirk of nature was soon to arise which would seemingly hold out the promise of vast wealth that anybody could speculate on…
Enter the Tulips
Tulips had been introduced to Europe around the mid-1500s, and had always held the promise of some value. In fact, they still do, as can be appreciated by remembering how famous Amsterdam is for that particular bloom. But something happened around 1634 that would cause the value of this plant to skyrocket, and that something was a virus. The virus, which was transmitted by aphids, lead to a couple of consequences for the tulip, both of which are the reason why a crazy speculative bubble arose. Firstly, the virus had the effect of transforming an ordinary solid-coloured tulip into a startling-looking variegated variety with beautiful flamelike petals. This was a much-prized variety, and as nobody really knew what caused such variegation there was much speculation as folks attempted to predict which bulbs would develop into the prized tulips.
Secondly, the virus ultimately killed the tulip. This made it something of a hot potato, in that you really wanted to sell the tulip on for a higher price rather than be the sucker who was left with nothing but a dead bulb.
Unlike shares in the Dutch East India Company or prized property, tulips were much more affordable, which meant more people could join in the speculation of this particular asset. Not surprisingly, given the stories of immense riches to be gained from selling on a prized bulb, many, many people were drawn into speculation. Most of these people were not experienced traders. In fact, the professionals pretty much shunned the tulip trade and continued investing in good old reliables such as East India stock. They regarded tulips as more of an expression of wealth than a means to that end.
But for more inexperienced traders, the chance of having and reselling a prized tulip was considered to be the means to great fortune. Because the tulip spends most of its life as a bulb rather than a blossom, it naturally lent itself to a futures market (something the Dutch called a windhandel, or the wind trade). By ‘futures market’, I mean a situation where both buyer and seller agree to the future price of a good, and when that specific time arrives, the buyer is obliged to pay the seller whatever amount was agreed upon.
However, waiting for that agreed-upon time to arrive was too slow for the growing crowds of speculators. Therefore, a move was made to transition from selling tulips themselves, and instead trading those futures contracts. And trade them they did, sometimes as much as ten times in one day. You can see then, how the value of tulips was entering into ever higher realms of abstraction. The trade in futures market contracts meant that people didn’t have to worry about an actual tulip being delivered. No, their only concern was being able to sell the contract for a higher price than they had bought it for. The result of this was that, at the very peak of the tulipmania during the winter of late 1636 and early 1637, a time when the bulbs were still dormant in the ground, not one blossoming tulip actually changed hands.
But there is even more to this tale of wild speculation than that. You see, not only were no bulbs being traded, no real money was, either. At that time, ‘real money’ was the guilder, the currency of the Dutch Republic. This was not the paper currency we are used to, it was money based on a specific amount of precious metal, 0.027 ounces of gold. Much of the trade in futures contracts was not financed with real money, but rather with ‘notes of personal credit’. In other words, with IOUs. So not only were there no bulbs being traded during the heights of tulipmania, no money was changing hands either. Instead, transactions were being made on nothing but the promise to deliver the money in the future.
According to Edward Chancellor, author of ‘Devil Take the Hindmost: A History Of Financial Speculation’, “by the later stages of the mania, the fusion of the windhandel with paper credit created the perfect symmetry of insubstantiality: most transactions were for tulip bulbs that could never be delivered because they didn’t exist and were paid for with credit notes that could never be honoured because the money wasn’t there”.
To give an idea of just how high the price of tulip bulbs rose (or, perhaps I should say, the price of the promise of such a bulb) consider that the highest record amount paid for a tulip at that time was a whopping 5,200 guilders. In gold terms, that’s nine pounds of the stuff. You could have bought eighteen modest-sized houses for the price of that one tulip.
It all ends
Like all bubbles, this one could not inflate forever. The end inevitably came, because the bulbs blossomed into flowers or turned out to be dead duds, and because the contractual dates for when IOUs had to be paid for with the promised money were coming around. The wealthiest were not hit too hard, since, if you remember, they had continued investing in things like townhouses and East India Stock. No, it was those less experienced in investing, the people caught it in crowd behaviour, buying into futures contracts for tulip bulbs for no reason other than that was what everyone else was doing, that got hurt the most. Inevitably, a lot of those people found out that their anticipated fortunes amounted to nothing but worthless promises. Fights broke out over the amount due per contract, and the Dutch government stepped in, declaring that the contracts could be settled for 3.5 percent of their initial value. On one hand, that was obviously preferable to paying the full contract. But nevertheless 3.5 percent of the most expensive tulip still equated to a year’s salary for some unfortunate citizens.
So that’s the story of tulipmania. What lessons can be applied to blockchain-based assets? Well, firstly, I don’t think it is all that fair to compare blockchain-based assets to ‘tulips’. A tulip does have some value. They are pretty things and people pay for pretty things. But you can hardly call a tulip bulb a general-purpose technology. A general-purpose technology is one that can be used in a great many ways. Examples would be ‘electricity’ or ‘computing’. Just think of all the inventions and industries and jobs that have been built on the basis of those two technologies. The blockchain is also a general purpose technology, and that means speculating on its future growth need not be sheer pie-in the sky. People who expect to make a fortune from crypto-assets might just be making educated guess regarding the future potential of Satoshi Nakamoto’s invention.
Having said that, all speculation is prone to crowd behaviour. Just because the underlying blockchain technology is sound, doesn’t mean to say that assets built on top of it can’t be scams designed to lure in suckers, or that genuine products can’t fuel asset bubbles as people buy or sell for no good reason other than everybody else is doing likewise. ‘It’s just like tulips!’ may be a retort used by skeptics who don’t really know all that much about cryptoassets and blockchains, but nevertheless the story of the tulip speculative bubble does hold some valuable lessons. After all, those who do not learn from history are doomed to repeat it.
“Capitalism: A Graphic Guide” by Dan Cryan, Sharron Shatil and Piero
“Cryptoassets: The Innovative Investor’s Guide to Bitcoin and Beyond” by Chris Burnsike and Jack Tatar.