By Guy Dorrell @GuyDorrellEsq
Mark Carney, the governor of the Bank of England, interviewed on Sky News’ Murnaghan programme spoke about the risks to UK economic recovery in particular “those risks that centre in the housing market”.
He was referring to the potential for overheating of a market with plenty of demand – much of it fuelled by foreign investment – but with a supply side providing half the stock of new builds compared with his native Canada.
Average asking prices UK-wide have increased 8.9 per cent in the year 2013-14, far above average wage increases for the same period. Additionally London, constrained from further excessive expansion by the Green Belt, has seen asking prices rise by 17 per cent, according to the ONS. A range of commentators have criticised the government’s Help To Buy scheme, which assists first-time buyers to buy property worth up to £650,000, for fuelling the demand side.
Carney might as well have told Dermot Murnaghan: “I’m going to define a housing bubble.”
Of course as a cultured and highly educated man, having attended both Harvard and Oxford universities and gained a doctorate in economics in the process, he will have been all too aware of the historical precedent.
English speculators have seen, and caused, a number of economic bubbles over the centuries. The South Sea bubble of 1720 happened when the South Sea Company was granted exclusivity on all assets that it could bring back from the South Seas and South America for trading in England. Untold riches were talked up and each successive share issue was sold out within hours of release.
Of course, the riches that investors had been led to expect never materialised and many were left with valueless share certificates, having been ruined by their wild speculation.
Bubbles are not an isolated phenomenon; wherever asset prices veer wildly from the intrinsic value of that asset a bubble in the trading is likely to follow. All too often investors have discovered too late the truism quoted by Native American tribes, “When the last tree has been cut down, the last fish caught, the last river poisoned, only then will we realize that one cannot eat money.”
Housing bubbles, it can be argued, are slightly different in that the intrinsic value is only monetised when the investor sells it on, and in the meantime they can live in the property. This is scant consolation where innocent buyers get caught in a maelstrom of negative equity caused by investors and speculators, when there is a truing up of the market.
The Case of The Tulip Bulb
But there is one historical case that stands out above all others that we should be wary of – one where the intrinsic value of the asset was so far removed from the asset price that it is astonishing to believe that anyone became involved at all.
Look back 377 years, to 1637 and to Amsterdam in the Dutch Republic. Amsterdam, then as now, was a major trading centre importing exotica from across the globe. It is also credited as having the world’s first Stock Exchange. The Low Countries are known for their harsh winters and Amsterdam and the surrounding areas had winters so harsh that art works from the time depict polders frozen over, with their surrounding watercourses frozen solid enough for crowds of ice skaters and even for skating races to be held.
Also at the time, trading from the Ottoman Empire, Persia and the near East brought many new commodities for sale and for examination. Dutch academic circles were flourishing, with the establishment of many institutes and faculties within universities to study some of the novel commodities traders were bringing back from their travelling.
One such was the University of Leiden’s hortus botanicus, the botanical gardens maintained by the university. A new variety of ornamental flower, the tulip, had made its way to Dutch shores. The tulip, perhaps from its traditional home of the mountains of the Hindu Kush, proved more hardy than many other flowers. This, plus its eye-catching colours and the beauty of its shape made it an instant hit among Amsterdam’s wealthy classes.
Merchants from Amsterdam could rely on each trading voyage yielding returns on their investment of 400 per cent, so the suburbs began to fill with estates reflecting the extravagance and social status that the merchants felt they were entitled to. Brightly coloured, sculpted ornamental gardens within each estate were de rigueur. Tulips, both standard colours and the newly-bred hybrids featured heavily.
Soon, the desirability of tulips, because of their association with wealth began to filter down to the middle classes. Tulips are an interesting asset, from an investors point of view, for a single bulb can produce two or three bud clones yearly, potentially tripling the return on investment. The appeal of the investment must be tempered by the fact that the investor must wait for between one to three years for the bud clones to become flowering bulbs themselves. However, this requirement for patience does have an upside for the speculator; supply side is naturally restricted.
Unlike many other varieties of flower and plant, tulip bulbs have a trait that the financially-astute Dutch took full advantage of; during the plant’s dormant period, a cultivator can uproot the bulb without affecting its growth or prospects. Burgeoning prices for bulbs and the ability to physically move and sell on the asset drove the creation of a spot market for plants that could see a single bulb have many owners, with successive price increases, before ever it came to bloom.
Tulip traders, florists, noted the emergence of the spot market and began to pile into contracts for the supply of bulbs for the up-coming season; an effective futures market. During this time, foreign speculators, the French, became involved in the market – and the governance of the market, further distorting the asset price to intrinsic value ratio.
As the asset price escalated, speculators emerged that would never even hold a tulip bulb. The problems associated with classic asset bubbles became so pronounced that Dutch authorities banned, by edict, short selling. Short selling, or shorting the market, took the same basic form then as it did when the Labour government suspended its practice in September 2008; a speculator borrows an asset and sells it, guaranteeing to re-purchase it before the expiry of a fixed time period. If the speculator can re-purchase at a price lower than the contract price that they sold for, the margin is profit for them.
The Tulips of London
At its peak, individual bulbs were being traded up to a dozen times daily. This practice resonates in the majority of economic bubbles from the 17th century to today’s modern luxury apartments in London, where a proportion of investors will never see the asset.
To use Mark Carney’s words, “the durability of the expansion” was finite. Something, at some point would cause the market to collapse. The asymmetric relationship of asset price to intrinsic value meant that when the market faltered, the bubble bursting was catastrophic.
Bulbs that had been worth 2,500 florins on the 3rd February – the equivalent of 20,000 lbs of cheese, were worthless 1st May. What had triggered the collapse? Asset inflation bubbles can only exist in bull markets, where market confidence is unquestioning. It seems probable that the turning of the bull market into a bear market happened due to the curtailing of the feeling of heady days going on forever by an outbreak of Bubonic plague in Haarlem, a centre for the auction of tulip bulbs.
Modern economists cast the tulip phenomena in a different light, arguing that the swathes of society that contemporary accounts purported to have been affected were exaggeration and a much smaller group of people were affected by the collapse. Since the contracts between buyers and sellers were essentially futures and no money actually changed hands, unless the sellers had committed the notional profit to a purchase on credit, neither party would be adversely affected.
Recent argument has also put forward that these traders were canny enough to have diversified their investments away from the tulip market alone and so avoided the worst privations of the collapse.
Certainly, the economic progress of the Dutch Republic carried on, more affected by the plague than by an economic bubble, with the concerns of the masses focusing upon the day-to-day struggle to survive the conditions of the day, rather than whether a small subset of oligarchs lost a fraction of their accumulated wealth; something that resonates today.