Don't burst the last bubble of economic fun, says Howard Davies.
There is not a lot of good clean fun to be had from the dismal science of economics. IS/LM curves supply a strictly limited amount of amusement for the average student. And even the "jokes" told about economists (there are three sorts of economists: those who can count and those who can't) have an unappealingly leaden quality. Gordon Brown may or may not have been joking when he referred to the thrills and spills of neo-classical endogenous growth theory, but he has certainly never attempted to repeat the trick.
So the occasional episode of apparent lunacy, when economic actors are seen to behave in a wholly irrational fashion, is particularly to be treasured.
It is quite inspiriting to think of all those stolid Dutch burghers losing their shirts as a single bulb of Semper augustus was sold one day for a price equivalent to all the tea in the Dutch Indies, and for a couple of guilders only a month or so later.
Sadly, future students of economic history are to be denied even this innocent amusement. Peter Garber's claim is that these three tales, far from being examples of irrational bubbles, are entirely comprehensible market episodes where the underlying economic schemes were sound and where market prices moved as might have been expected in the light of changing fundamentals. Indeed, Garber is rather stern with the rest of us, who have revelled in tulip mania in the past. We have been gulled, he thinks, suspending our usual critical faculties in the face of a good story: "The wonderful tales from the tulip mania are irresistible to those with a taste for crying bubble, even when the stories are so obviously untrue. So perfect are they for didactic use that financial moralisers will always find a ready market for them in a world filled with investors ever fearful of financial Armageddon."
How persuasive is this line of argument? Does Garber make his case? It should be said, first, that he does not help himself by writing in the most turgid style imaginable. Garber is a professor of economics at Brown University in the United States, and also a "global strategist" at Deutsche Bank. So one should perhaps not be surprised that his prose is an inelegant cross between the first draft of a PhD thesis and a broker's circular.
But somewhere hidden in the verbiage is a straightforward argument. Essentially, Garber makes three points: first, that economic historians of these bubble episodes have been inaccurate in their description and sloppy in their analysis; second, that the pricing movements observed in these episodes were fundamentally rational; and third, that the theory erected on these episodes - that markets are prone from time to time to bouts of irrational exuberance that cannot otherwise be reasonably explained - is of no use whatsoever in the analysis of financial market conditions today. In short, he aims not only to burst the bubbles, but also those who inflate them.
The first point is, I find, well proven. It is quite shaming to note that most of those who have written on tulips have used secondary, or even tertiary sources, and the nearest thing to a primary source is a moralising tract inspired by a Dutch government determined, for its own reasons, to dampen down market speculation. Garber, who has spent considerable time digging over the tulip fields of Holland, finds no evidence that the most famous transaction - a single bulb sold for 3,000 guilders (£865) - ever took place. The source almost always quoted in descriptions of the tulip bubble is a book by a man called Charles Mackay entitled Extraordinary Popular Delusions and the Madness of Crowds , first published in London in 1852. Subsequent scholarly analysis in Holland has pointed out that Mackay's work was not based on careful assessment of the tulip market or on contemporaneous records of prices actually paid.
Garber also shows that the notion that there was a huge bubble, whose puncturing caused serious economic disruption, figures nowhere in the most authoritative economic histories of the period. And the transactions most frequently quoted are sourced to a hypothetical illustration of what a bulb might have cost at the peak of the speculation. He shows that most historians of the period, including Simon Schama, have taken these apocryphal tales as gospel truths, and Schama "even feels free to weave his own fictions around the story".
This is all good knockabout stuff, in the great tradition of debunking. Garber does not speculate on why these tales have been so readily swallowed by otherwise sceptical historians. Perhaps it is the thirst for light relief that has caused so many to suspend their critical faculties.
Garber does not attempt to deny that there was a boom and bust in tulip bulbs in 1636-37. Indeed, he pieces together information from a variety of sources, and usefully summarises the price history in a table and a series of charts. They do show some remarkable price movements, particularly at the end of the period. But he goes on to invite us to take a further leap and to see both the tulip bubble, and the other two episodes - the Mississippi Scheme and the South Sea Bubble - as stories with a straightforward underlying economic rationale. Here, he is on less firm ground. He has not researched the other two episodes in anything like the same detail. Indeed, this book is based on a monograph about tulips first published in the Journal of Political Economy in 1989. In the other cases, he is guilty of using only secondary sources. His arguments that both John Law and the inflaters of the South Sea Bubble were early Keynesians whose schemes might well have turned out to be successful, are not wholly persuasive. And even in the case of tulips, while he digs up some interesting data on the prices of individual flowers (the consumption goods, rather than the underlying assets) in contemporary Paris, he does not sustain his contention that, even at the extravagant prices paid at the height of the boom, individual bulbs "do not appear obviously overvalued". To me, they do.
His third argument, and the one that is potentially of most general application, is that there is little value in the argument that markets are subject to bouts of irrational exuberance. He maintains that "bubble theories are the easy way out - they are simply names that we attach to that part of the asset price movements that we cannot easily explain. As tautological explanations, they can never be refuted. The goal here is to find explanations with some measure of economic and refutable content."
I can see that it is unsatisfactory to produce explanations of economic events based wholly on the assumption that actors were behaving irrationally. Garber is particularly cross with Alan Greenspan who, he maintains, has "removed all meaningful content from the concept" of irrational exuberance. This is a striking example of lèse majesté in relation to the chairman of the Federal Reserve Board that is rarely observed these days on either side of the Atlantic.
But there may, nonetheless, be more content in the irrationality explanation than Garber is prepared to allow. He rather caricatures the irrationality argument to make a point. And he does not properly address the view that markets, while fundamentally rational, may nonetheless be prone to bouts of overshooting. The most recent and vivid example is the price performance of dotcom stocks over the past 12 months. It was demonstrable, and indeed demonstrated by Goldman Sachs and others, that the prices paid for dotcom stocks in the spring of 2000 could not be supported on any plausible assessment of the net present value or the likely future earnings of these stocks. To be content to pay the prices quoted, one needed to believe in wholly implausible assumptions about corporate profitability, and the potential share of the communications sector, broadly defined, in the economy.
Some have argued that dotcom stocks should be seen, rather, as highly leveraged options, and that their prices may be explicable in that context. But even that analysis does not explain the euphoria that led to the price of 580p for lastminute.com in March last year. The market sentiment that led to that price may or may not be best described as irrational exuberance, but it is quite tough to produce persuasive analysis based on economic fundamentals.
So on Garber's third point I feel bound to enter a verdict of not proven. He warns us, quite rightly, to be careful when seeking refuge in explanations of markets based on some underlying irrationality. But he does not persuade this reader that there is no such thing as an over-excited, irrational investor.
Howard Davies is chairman, Financial Services Authority.
Famous First Bubbles: The Fundamentals of Early Manias
Author - Peter M. Garber
ISBN - 0 262 07204 1
Publisher - MIT Press
Price - £16.95
Pages - 163