It was called Tulip Mania. As the story goes, the prices of tulips skyrocketed here
in the Netherlands in the 1600s, and then crashed. It’s seen as the first example
of an economic bubble. So what are bubbles, and
what causes them to burst? Throughout the years, there have
been all sorts of economic bubbles. Tulips, real estate, dotcom
companies, maybe even bitcoin. But they all have one
thing in common. Investors pay more for an asset than may actually
be justified, resulting in surging, sky-high prices. Let's use Tulip Mania as an example to
understand the anatomy of a bubble. Economists have laid out five
stages of an economic bubble. Stage one? Displacement. It's when investors start to get very excited
about a new or innovative product or technology. That's what happened in the
Netherlands in the 1600s. The country was experiencing a surge in
wealth thanks to booming international trade. Tulips were seen as luxury items. They
were rare, and they take a long time to grow. By the mid-1630s, the Dutch
had gone wild for tulips. More and more buyers drove
up the prices of tulips fast. By some accounts, the price for a single rare
type of tulip bulb was equivalent to $50,000. That brings us to the second stage of
an economic bubble: a price boom. In recent years, we’ve seen this
happen with the dotcom bubble when shares of the NASDAQ, which tracks
tech stocks, spiked in the late 1990s. Or more recently, when the price of bitcoin roughly
tripled in just one month at the end of 2017. Price booms come back to
the simple rules of economics. Let’s say there’s a limited
supply of a product. If everybody wants a piece of it, there’s a lot of
demand. That causes prices to go up. There was only one tulip crop per year. So
there was limited supply and a lot of demand. Because tulips can only be harvested
during certain months of the year, the Dutch starting buying
tulip futures contracts. They were putting a bet on the future price
of a bulb that they didn’t have in hand yet. Even though it was impossible for Dutch buyers
to completely predict the future price of a tulip, they were confident they’d be able to sell
it for a higher price than what they paid. This is the third stage of an
economic bubble: euphoria. It creates a trading frenzy as more and
more buyers try to get in on the market. But then some investors begin to realize that
the actual value of a product, like a tulip, isn’t in line with what they
paid, and so they cash out. This is called the profit-taking
phase or stage four. I mean, could a single tulip bulb
really be worth $50,000? Buyers started to lose trust that they were
worth that much, and so they started to sell. By 1637, the prices of tulips plummeted. Which brings us to the final
stage of a bubble: panic. This is when everyone
realizes how crazy it is that they had paid as much for a tulip
bulb as, say, a house in Amsterdam. That’s when they decide it’s
time to get out of the market. Selling, selling and more selling
ultimately causes a bubble to burst. We saw panic during
the dotcom bubble, as the NASDAQ tumbled around
40% in the second half of 2000. Bitcoin’s plunge in early 2018
suggested that bubble had burst, as the value of the cryptocurrency was
roughly cut in half in just one month. One takeaway from Tulip Mania
or other more recent bubbles is that prices are influenced by how
much buyers are willing to pay. When a group of buyers gets excited about a product,
like a tulip, they might not act rationally about its price. This can make predicting
and preventing bubbles tough. Traders, economists and central bankers all can
get pretty obsessed with identifying the next bubble. After all, the burst of the
housing bubble in 2008 contributed to the worst financial
crisis since the Great Depression. It’s important to know that
not all bubbles do burst. Sometimes price swings are
just part of supply and demand, and don’t have spill over effects
to other parts of the economy. Here in Amsterdam, Tulip Mania
did have one lasting effect. The flowers are still a staple in the
city nearly 400 years after the bubble. Hey everyone, Elizabeth here.
Thanks so much for watching. Where do you see bubbles in the market?
Let us know in the comments section. And while you're there
subscribe to our channel. Be sure to check out more of our
CNBC Explains videos over here. Talk to you later!
