Tulips, Credit Cycles and The Risk Subsidy


Around four hundred years ago the Tulip was introduced into Europe from the Ottoman Empire.  The flower’s spectacular colorful variations of patterned petals, now understood to be caused by a type of Mosaic Virus, quickly endeared the bulbs to the wealthy classes as status symbols.  The dutch market in futures contracts which emerged for Tulip bulbs went on to become the first recorded example of an economic bubble.  At the market’s peak a single bulb of a high demand variety, such as “The Viceroy”, would fetch around three to four thousand florins -about ten times the yearly earnings of a skilled craftsmen.  To put it in modern terms, we are talking about something on the order of a million dollars – for a flower bulb.

That’s the simple version of the story, “Tulip Mania“, which by its name alone conjures up some early version of a frenzied Wall Street trading pit in the throes of a full-blown profit craze: the very textbook example of irrationality in economic agents.

Or is it?

The traditional account of the story has been challenged more recently.  The new story is more complex, involving war, plague, and legislative changes to contractual obligations.  In the modern analysis the rise and fall in Tulip prices, far from being a textbook case of bubbling irrationality, was perhaps actually an example of the so called perfect market hypothesis in action.

On that note, there is something suspicious about the very idea of intrinsic value as typically used in the context of economic bubbles, as in “trade in high volumes at prices that are considerably at variance with intrinsic values“.

What is the ‘intrinsic’ value of a Tulip?  At the time of the ‘mania’, Tulips were novel, interesting and rare, so they fulfilled a niche as a status symbol.  Value is inherently subjective and varies both inter-agent and intra-agent across time, and can only be measured by exchanges.  If I am buying a Tulip from you for a million dollars, I am defining my spot valuation of a Tulip to be greater than a million dollars, and you are defining yours to be less.

As the market for Tulips developed, some agents began purchasing Tulips not because they themselves actually valued the bulbs more than market prices, but rather because they believed that other agents would, and thus they could profit on the difference.  If one attempts to exploit a spatial arbitrage opportunity, one is called a merchant trader.  If one seeks temporal arbitrage, then one is called a speculator.  But in reality there is little fundamental difference between the trader who buys Tulips in Turkey and attempts to sell them for more in Germany and the trader who buys in 1630 and sells in 1635.

In both cases the trader has found a niche in the economic ecology, helping to even out discrepancies in supply and demand across time and space.  Without such traders, the tulips would very well never have made it out of their original region, and would have been overconsumed by early adopters.  The traders attempt to help ensure a maximization of aggregate valuation: that the tulips are distributed to those who value them most.

But people are complex, fickle beasts.  Our tastes and valuations change with the wind and the season.  Let the trader beware.  Bubbles happen not because of some original flaw of rationality in man which can only be overcome through the salvatory interventions of a higher bureaucratic power.  Bubbles happen because minds are too complex to be accurately predictable by speculators and sometimes, in retrospect, people make mistakes.

Savings and Credit Cycles

Consider a model society where everyone spends exactly what they earn, without possibility of debt or savings.  Now imagine the introduction and adoption of the revolutionary idea of spending less than you earn currently to accrue a stock of credit money so that you can spend more at some point in the future.  We tend to think of saving money as being equivalent to a squirrel stockpiling acorns, but the paradox of money is that it actually has no intrinsic value (with a few minor memorable exceptions such as paper currency functioning as kindling).

If our model society went from spending 100% of it’s income to spending only half and saving the rest (as in actual stockpiling of cash, not investing), all else being equal the GDP or net money flow would be cut in half.  An economist would quickly point out this would cause a recession as the lowered prices would be interpreted as signals for lowered demand, and production would fall.

But imagine that our rational simpleton society is a paragon of the predictable market hypothesis, a simpler cousin to the efficient.  The transition to a thrifty economy is near instantaneous, and imagine that everyone would know for certain that the change would be permanent and everyone would save 50% of their income – indefinitely into the future.  Rational bids on prices and wages would soon cut them in half, and the economy would continue on as if nothing had happened.  The supply of housing, raw materials, labor, or anything else wouldn’t change overnight, so a rational market with full knowledge of a permanent cut of monetary demand by 50% would rapidly adjust prices accordingly without effecting supply in the slightest.  Your house, car and net value would be slashed in half overnight, you’d gladly take a paycut down to half your previous salary, and yet life would go on as if nothing had happened.  Because indeed, nothing would have changed except for an arbitrary numeric constant.

Money has no intrinsic value, it has no rest mass.  Money that will never be spent at any point in the future might as well have dissappeared into a black hole.

The real world of course is different: shifts in overall savings rates occur fairly slowly, savings are understood to be eventually spent, agents are far from perfectly knowledgeable or rational, and price changes and wages do not react instantaneously to changes in the flow of money.

A transition from a high savings society to a high spending society mainly increases nominal GDP and causes inflation, but it also increases real GDP (however measured) to some lesser extent as material and energy reserves are depleted at a higher rate and these extra resources are employed to increase production.

In a normal rational market society, business credit cycles are to be expected, with money flowing out of savings and fueling inflationary growth during times of rapid change and business opportunity.

Eventually the reserves of saved money are depleted and the inflationary portion of the expansion is slowed or halted.  This tends to then lead to deflationary periods where savings are restored.  These cycles are fully natural adaptations to disruptions in the economic environment such as new technologies rippling through the economy.

The growth periods surrounding the adoption of technologies such as the railroad, automobile or internet were all great investment opportunities.  In the deflationary contractions that followed saving money became a better option than investing as the ripple effects of the new technology dispersed and the market niches filled up.  Cyclic booms and busts are thus to be expected even in a world with fully rational agents.

Of course we don’t live in such a world. Ours is just a tad crazier.


Imagine a simpleton world again where the concept of debt does not yet exist and is then suddenly introduced.  Debt develops in this world in the form of personal loans or bonds, where individuals sell a contract to repay principal plus some interest years in the future.  Initially the simpletons only exchange these bonds for cash, freeing up the stock of previously accumulated savings.  Before the bond revolution, only people who had saved for many years or had inherited savings could start a business or purchase a house.  Now a young person could acquire money by selling a debt bond in exchange for the savings of another.  In this model society of naive simpletons, when the time came to pony up, enthusiastic debtors could even pay off their initial debts by taking on yet another slightly larger debt.  The debt boom would unleash the savings floodgates and lead to a huge flow of money into the system, causing a full blown inflationary expansion.

Unfortunately the debt boom will tend to end poorly when all of the savers have exchanged their money reserves for debt bonds and all the cash is unleashed.  At this point the credit runs dry and debtors have to actually repay or default.

However, imagine if the singletons find it acceptable to exchange their debts directly in lieu of actual money.  Now a young debtor could purchase a house or other large investment directly by issuing a new bond to the owner, without having to first find an intermediary creditor in possession of actual money.

In this simpleton society where everyone was sufficiently trusted, the inflationary boom need not have an end.  Everyone could continue to issue new debt continuously to make purchases and then repay old debt by taking on even more new debt.  In essence debt itself would thus become a new form of money, but with unlimited decentralized money creation the result would soon be runaway exponential inflation.

Of course in the real world people are not simpletons and wisely generally lack the trust required to permit a runaway personal debt boom.

So that is not quite our society, but we do somehow live in a world where debt has replaced money.  The difference is that we have centralized our trust and handed over control of debt away to a monopoly.

From Debt to Banks

In a world of complex agents, a successful creditor will ensure that the interest charged for loans more than compensates for the risk of default in order to realize profits.  In a competitive world, successful creditors will over time come to control the supply of credit.

Accurately assessing the risk of a particular potential debtor is time consuming and shareable, so creditors may want to outsource and pool that service.  A professional credit intermediary could also pool credit assets and allow for liquidity conversion.  Debtors may prefer long term repayment while creditors prefer more immediate monthly payments or shorter terms.  A large enough entity could convert between these needs.  Thus there is a niche for banks.  If creditors want 1 year loans but debtors prefer 10 year loans, a bank can step in and buffer the time preference.  With a sufficient initial buffer, as long as the aggregate income from the debtors exceeds the outgoing payments to the creditors, the bank can profit on a form of time preference arbitrage.  The important messy aspect to a net efficient credit pool of this form is in how default risk is distributed.  The most sensible scheme would be to spread it out.  If there is a sudden surge in defaults and or drying up of credit, first the bank would lose profits, and then the losses would be distributed back amongst original creditors.

The most important and chaotic form of debt is perhaps the highly liquid on demand deposit.  This scheme provides the creditor apparent security via the option of withdrawing the money on demand.  It is essentially like a loan with a one second time period that automatically renews unless otherwise specified.  From the creditor’s perspective this appears to be as good as cash.

The problem is of course that it clearly is not quite as good as cash, because it still carries inherit risk which is difficult to distribute.  In the event of an unexpected liquidity crisis, ie a bank run, the first depositors to rush and collect will get paid out until the bank’s cash and other liquid assets on hand are depleted.  The losses are then fully carried by the slowest depositors.  A more equitable scheme would have demand deposits convert in a liquidity crisis to longer term loans, or perhaps shares spread across the bank’s investments, such that losses are then distributed across the creditors.

In a fully rational world, agents would understand that demand deposits (such as checking accounts) are not really equivalent to cash, that they actually are loans which carry the risk portfolio of the bank’s investments.

In other more rational worlds, perhaps banking systems evolve into something more like transparent credit unions, where depositors are the shareholders and the bank’s investments are fully public and open.

In our world banks evolved in real world mixed market democracies. In the long term banks that make overly aggressive or excessively poor investments collapse and are out-competed, but much can happen in the short term.  Riskier banks can grow aggressively during market booms.  Legal infrastructures can be slow to adapt, and in turn can succumb to the influence of banking wealth.

Depositors think they are storing their savings safely, but in reality they are loaning it out to fuel the end stage of an investment bubble while the bank is grabbing all of the interest earned as profit.  When the investment growth peaks, loan defaults build up, and a panic sets in.  The bank may default and go bust, but by this point the bankers have already earned their profits.  The outcome of market competition does not evolve along some quick straight line path towards a global all-party optimum, and much depends on the legal environment.  It is generally not in a business’s best interest to have a fully informed consumer.

The Risk Subsidy

Today banking is a quasi-public cartel industry.  The industry has succeeded in protecting itself against innovation through a combination of a powerful federal subsidy and dense regulatory barriers.  The government subsidizes away much of the risk through direct insurance plans such as FDIC.  Through this guarantee checking deposits became nearly equivalent to cash, cementing their usurpation or virtualization of physical money as the new currency.  The insurance subsidy is essentially a risk subsidy, socializing the primary default risk and providing a powerful incentive for creditors to use on demand deposits and prop up banks.

Subsidizing risk through socialized deposit insurance probably lowers interest rates in and of itself (by increasing demand for the perceived lower risk on-demand deposits), but the primary function of central banks today has become that of directly subsidizing loans to banks at low interest rates.

Subsidizing bank loans to force interest rates down to nearly zero, as the fed has been doing for much of the last two decades, stimulates a flood of artificial credit which simulates the tapping of savings reserves in a growth cycle (and more generally a demand shift towards holding riskier, higher yield assets such as investments or real estate).

Interest rates represent or reflect the aggregate risk and inflation weighted return on investment.  If interest rates are lower than the real return of investment opportunities, investors will arbitrage this until profitable opportunities diminish, savings are depleted and rates rise.  If interest rates are higher than the real return, investments will diminish and saving stimulated until they equalize.  A natural interest rate tends to evolve towards this equilibrium which essentially represents the market’s confidence towards investing in the future.

By subsidizing risk and lowering interest rates, the central banking apparatus provides us with the convenient illusion of an economic boom: forced overconfidence.  The Austrian School appears to be right on this at least.  The mainstream view appears to place more of the blame for recent low interest bubble expansions on an Asian savings glut, which contributes, but the fed clearly has some role.  At the very least, through the risk subsidy the fed has helped hawk our overpriced speculative debt investments to Asian savings markets.


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