Tulip Mania - Legal Changes

Legal Changes

UCLA economics professor Earl A. Thompson argues in a 2007 paper that Garber's explanation cannot account for the extremely swift drop in tulip bulb contract prices. The annualized rate of price decline was 99.999%, instead of the average 40% for other flowers. He provides another explanation for Dutch tulip mania. The Dutch parliament was considering a decree (originally sponsored by Dutch tulip investors who had lost money because of a German setback in the Thirty Years' War) that changed the way tulip contracts functioned:

On February 24, 1637, the self-regulating guild of Dutch florists, in a decision that was later ratified by the Dutch Parliament, announced that all futures contracts written after November 30, 1636 and before the re-opening of the cash market in the early Spring, were to be interpreted as option contracts. They did this by simply relieving the futures buyers of the obligation to buy the future tulips, forcing them merely to compensate the sellers with a small fixed percentage of the contract price.

Before this parliamentary decree, the purchaser of a tulip contract—known in modern finance as a futures contract—was legally obliged to buy the bulbs. The decree changed the nature of these contracts, so that if the current market price fell, the purchaser could opt to pay a penalty and forgo receipt of the bulb, rather than pay the full contracted price. This change in law meant that, in modern terminology, the futures contracts had been transformed into options contracts. This proposal began to be debated in the fall of 1636, and if it became clear to investors that the decree was likely to be enacted, prices probably would have risen.

This decree allowed someone who purchased a contract to void the contract with a payment of only 3.5 percent of the contract price (or about 1/30th the contract). Thus, investors bought increasingly expensive contracts. A speculator could sign a contract to purchase a tulip for 100 guilders. If the price rose above 100 guilders, the speculator would pocket the difference as profit. If the price remained low, the speculator could void the contract for only 3½ guilders. Thus, a contract nominally for 100 guilders, would actually cost an investor no more than 3½ guilders. In early February, as contract prices reached a peak, Dutch authorities stepped in and halted the trading of these contracts.

Thompson states that actual sales of tulip bulbs remained at ordinary levels throughout the period. Thus, Thompson concludes that the "mania" was a rational response to changes in contractual obligations. Using data about the specific payoffs present in the futures and option contracts, Thompson argues that tulip bulb contract prices hewed closely to what a rational economic model would dictate, "Tulip contract prices before, during, and after the 'tulipmania' appear to provide a remarkable illustration of 'market efficiency'."