The Economics Book

98

CROWDS BREED

COLLECTIVE

INSANITY

ECONOMIC BUBBLES

I

n 1841, the Scottish journalist

Charles Mackay published

Extraordinary Popular Delusions

and the Madness of Crowds, a

classic psychological study of

markets and the irrational behavior

of people acting in “herds.” The

book looks at some of the most

famous examples of frenzied

speculation in history, including

Tulipomania (1630s), John Law’s

Mississippi Scheme (1719–20), and

the South Sea Bubble (1720).

Mackay’s hypothesis was that

crowds acting in a collective frenzy

of speculation can cause the prices

of commodities to rise far beyond

any intrinsic value they might

have. When assets rise in such an

uncontrolled way, the situation is

called an economic bubble. Like

actual bubbles, in an economic

bubble prices rise upward but

become more and more fragile—

and they inevitably burst.

Tulipomania

The Dutch tulip mania of the 1630s

is one of the earliest and most

notorious instances of an economic

bubble. At the beginning of the 17th

century tulips from Constantinople

became popular with the wealthy

of Holland and Germany, and soon

everyone wanted them. Tulips were

seen to bestow the qualities of

wealth and sophistication on their

owners, and the Dutch middle class

became obsessed with collecting

rare varieties. By 1636, the demand

for rare species of tulips was so

intense that they were traded on

Amsterdam’s stock exchange.

Many individuals grew suddenly

rich. A golden bait hung temptingly

out before the people, and

everyone—from noblemen to

maidservants—rushed to the tulip

markets, all imagining that the

passion for tulips would last forever.

But when the rich stopped planting

IN CONTEXT

FOCUS

The macroeconomy

KEY THINKER

Charles Mackay (1814 –89)

BEFORE

1637 Dutch nurseryman P.

Cos publishes The Tulip Book,

which provides raw data for

the future prices of tulips.

AFTER

1947 US economist Herbert

Simon writes Administrative

Behavior, introducing the idea

of “bounded rationality”—poor

decisions are due to limits in

ability, information, and time.

1990 Peter Garber critiques

Mackay’s work in his essay,

Famous First Bubbles.

2000 US economist Robert

Shiller publishes Irrational

Exuberance, analyzing

the causes and policy

interventions that might

prevent the occurrence of

future economic bubbles.

Hendrik Pot’s painting of tulip mania

(1640), shows the goddess of flowers

riding with drunken, money-weighing

men. Other people follow the cart,

desperate to keep up with the group.