Friday Book: Tulips, a model for the modern stock market

Tulipomania by Mike Dash (Gollancz, pounds 14.99)
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AT THE height of the tulip mania in 17th-century Holland, it was not unusual for prized bulbs to exchange hands for a price equivalent to six warships. In the four years from 1633 until the bubble burst in early 1637, the bulb trade utterly dominated the economy.

Not surprisingly, people are fascinated by comparisons between this most famous financial mania and modern equivalents such as the stock market craze for shares in Internet companies. After all, the vogue for day trading in the US, whereby individual investors buy and sell dozens of shares for immediate profit or loss, has driven one American loser to mass murder. And the bubble hasn't burst yet.

Tulipomania is an excellent resource for assessing our modern mania, although the reader has to have a certain tolerance for the historical detail. The book does not quite make it as a ripping yarn. I was fascinated to learn, however, that tulip bulbs really are edible, although apparently tasting rather bitter. The Dutch ate them during the "hunger winter" after the end of the Second World War.

Yet Mike Dash does make clear some parallels between now and then. Tulip mania was made possible by financial innovation. Initially the trade involved physical exchange of the bulbs, but the main disadvantage of this was that it limited the trading season until summer, when bulbs were lifted before being replanted in autumn.

So from 1635, the increasing numbers of speculative growers, as opposed to genuine connoisseurs of the beautiful flowers, started to trade in promissory notes. These gave the details of what flower was being sold and when it would be lifted. Signs stuck into the ground next to plants recorded what type they were and who owned them. This marked the creation of a futures market, still a novelty.

By agreeing to sell and buy bulbs that would not be available for several months, traders started to speculate on the future price. As long as everybody expected that price to continue to rise, it was an irresistible investment. The first ingredient for a bubble had been set in place.

The second was the fact that purchases required only a 10 per cent deposit. This encouraged "short selling" - the practice of selling something that you do not yet have, confident that the price for which you eventually sell will be higher than the price at which you have had to buy.

Short selling is fine in a rising market but disastrous in a falling one. Investors can end up with obligations to pay far more than they own. The Dutch government banned the practice in 1621. And again in 1623, 1624, 1630 and 1636. The law was obviously a weak instrument against the chance of untold profit. Worse still, many small investors had sold all their assets in order to speculate.

The final element was the scarcity of tulip bulbs, especially the prized varieties with magnificent streaks of colour, caused by an unpredictable virus. The bulbs were introduced from Asia only at the very end of the 16th century - not all that many growing seasons. As the mania grew, there was more and more demand for a supply that increased only slowly.

This is one key difference between tulipomania and a modern financial bubble. There is no shortage of new Internet start-up companies issuing shares. This is not to say that the current boom will not come to a sudden end. Many pundits are predicting just that, in large part because it is fuelled by credit that could dry up at the first sign that prices might fall.

However, there is a more fundamental difference between the tulip boom and the Internet boom - or, for that matter, the railway boom of the mid- 19th century. No matter how much an investor pays for a bulb, what he ends up with is a flower. If he is a good gardener he may be able to turn it into many flowers.

Put money into speculative shares and you may end up owning part of the next IBM or ICI. The modern stock market channels savings to potentially useful investment in the future of the economy. This, while risky for individuals, is essential for economic progress. Even after share prices had fallen by more than two-thirds in the great crash of 1929, some investors ended up with once-speculative radio shares that had turned into RCA.

This makes tulipomania the exception among bubbles, rather than the model for them. The get-rich-quick urge of modern investors has no such passion for pure beauty at its root.