3 Origin of Asset Price Bubbles

Augustus, the most precious bulb, located in the Dutch cities of Harlaem and Amsterdam. For the one in Harlaem, the investor gave to the seller “twelve acres of building ground”. For the one in Amsterdam, the price paid was “4600 forins, a new carriage, two grey horses, and a complete suit of harness”. Kindleberger and Aliber (2005) explain that in the autumn of 1636, the price of tulips increased by several hundred percent. At this point, it was perceived that rich people were purchasing tulips only as an investment. Potential investors rapidly understood that they could only make a proft, if the price of tulips kept rising. When enough people became aware of that impossibility, prices collapsed. We also want to emphasize that the Tulipmania was also feasible because the Dutch economy was booming during the 1630s after the war with Spain in the 1620s (Kindleberger and Aliber 2005). That is, if the popularity in tulips had coincided in a period of low economic growth, we would not have observed these increases in the price of tulips.

We next turn to the South Sea Bubble (1720). The interested reader is referred to Temin and Voth (2004) and references therein for further information. The South Sea Company was founded in 1711 with the purpose of trading with Spanish America. However, from the very beginning, its main source of revenues was the conversion of national debt (of England) into stocks. Both the government and the South Sea Company profted from this conversion. On the one hand, by making government debt more liquid, the government fees declined. On the other side, the South Sea Company received the payments from the government and the revenues from issuing the stocks. The mania started when the government agreed to grant monopoly rights to convert the rest of its national debt into stocks to the company who made the best offer. In addition to the South Sea Company, the Bank of England, which was also a joint-stock company, made a competitive bid for this monopoly. In April 1720, the parliament granted the conversion to the South Sea Company. There is an important feature that helps to explain the ensuing sharp increase in stock prices. The South Sea Company was allowed to issue more equity to fund (pay) the operation. It is in this moment that the company engages into a classic Ponzi scheme (according to Kindleberger and Aliber 2005). Roughly speaking, a Ponzi scheme is when the return of old investors depends on the investment of new investors. That is, if the company does not keep receiving money, it cannot pay old investors. Eventually, investors realized that there were no more incoming investors to fund the South Sea Company and the asset