Holland's Tulip Bubble of the 1630s: when derivatives wreaked havoc! Source: heatusa.com
Even sound actions can have negative consequences. That is why in times of crisis, policy makers must remain vigilant. Easing monetary and credit policies last year and keeping them loose made sense. In an effort to avoid the mistakes of the Great Depression, when governments tightened both monetary and fiscal policies, policy makers this time around gave the wounded private sector what it needed to avert a panic. But these sound policies now have negative consequences. The Economist reports in a nice leader this week that financial asset prices the world over have risen too much and do not reflect the reality of economic prospects. This is called a bubble and we’ve seen them time and time again — the last one being the housing bubble that ended last year, fueled by financial derivatives that bundled risk, too complex to understand.
Derivatives weren’t born yesterday, however. During the Golden Age of Holland, when that scrappy nation was a world power and trading juggernaut, there was the infamous tulip bubble of the 1630s (see image above), which was also fueled by derivatives. Yes, tulips. Colorful flowers introduced into northern Europe from Ottoman Turkey. Tulips were what every up-and-comer had to have to prove his/her social status, much like a Manhattan pied-a-terre or a Florida beach house today. The tulips bloomed in season, but you could buy a futures contract any time of year for delivery of tulips in the future. This fueled a speculative run-up in tulip prices, which when the bubble burst, left some investors ruined. After all, they’re only flowers…
Another bubble — this time in stocks and bonds — could burst this year, as the reality of the “new normal” of slow growth (with a side of inflation) sinks in. Unfortunately, this time around governments are in such a fiscal mess, they will not be able to bail out the private sector. This could mean a “double dip” Great Recession. Policy makers should plan for this today — developing medium-term fiscal consolidation plans to bolster credibility, keeping the lid on current spending, scrapping health care “reform,” and perhaps beginning to nudge interest rates higher later this year. The latter has to be done carefully so as not to spark the very double dip we are trying to avoid. I never said it would easy.
Image above: Holland’s Tulip Bubble of the 1630s: when derivatives wreaked havoc! Source: heatusa.com