The year was 1637. The Dutch had captured the spice trade a few decades earlier and had supplanted the Portuguese as masters of the sea. The Netherlands was the most important and powerful nation on earth. The Dutch East India Company was at the height of its influence. This remarkable organization, originally founded around 1600 to support a single expedition, was the first firm to issue stock, the first conglomerate, and the first multi-national corporation.
During this century of change, Dutch scientist Christian Huygens developed wave theory and revolutionized optics, while Antonie van Leeuwenhoek crafted surprisingly advanced lenses and microscopes. Dutch philosopher Baruch Spinoza, a humble lens maker himself in his “day job,” became a leading ethicist and laid the foundation for the Enlightenment a century later. Dutch artists such as Rembrandt, Rubens, and Vermeer gave us new perspectives on the use of light. The country was the economic, technology, and cultural marvel of the world. (Sound familiar?)
In the 1630s, the Dutch merchants returned from the Ottoman Empire with a seemingly innocuous new pleasantry known as tulip bulbs. If properly nurtured in the fertile soil of the area, they would produce unique and beautiful flowers. These bulbs soon became all the rage and set off a buying frenzy. As buyers bid the costs ever higher, it seemed that there was no end to the prospects for profit. At the peak in early 1637, a single bulb commanded a price in excess of that for twelve acres of prize land. But, alas, the bubble burst, and fortunes were lost even faster than they were made. Even the powerful Dutch economy took a while to fully recover.
You would think this whole affair would have taught us once and for all the folly of such speculations. History shows us, however, that nothing could be further from the truth. It is almost 400 years later, and whether it’s precious metals, oil, syndications, dot.com stocks, or home mortgages, we simply can’t resist the temptation to ride these waves.
The past couple of weeks have had the markets reeling. Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, Goldman Sachs, AIG, and others have all made their moves in various ways. The government is engineering a $700 billion (at least for now) purchase of distressed assets, and markets are working overtime to take it all in and make sense of it.
How did all of this happen over the simple act of expanding home mortgages? What began as a well-intentioned and noble effort to increase the availability of the “American Dream” went terribly wrong. The major culprit was greed, but there is plenty of blame to go around. Governmental agencies and policies enabled and even encouraged loose lending practices. Eager lenders and brokers would originate loans for quick profits. Eager buyers would purchase securities backed by pools of these mortgages, pushing for ever higher yields (and, hence, even poorer underwriting quality). The stock market was suffering in the wake of the corporate accounting scandals, and trillions of dollars were “hot” to find a new place to go. As the economy became ever more global, investors from other nations flocked to these instruments.
The myth underlying part of the resulting problem is that diversification eliminates risk. There are well-established principles by which we can reduce exposure through intelligent spreading of investments, but if an entire portfolio of mortgages is inherently unsustainable due to its very structure, the fact that they are bundled together cannot make them viable.
This particular bubble is bigger than most. The responses will change the very nature of our financial markets (at least temporarily), but they will not eliminate our tendency to speculate. The key to effective policy is to allow markets the freedom to do the things they do well, restrain the unbridled exercise of greed, but not to go so far that we stifle the creativity and innovation necessary to promote economic growth.
We have learned a lot over the years. Without today’s technology and global integration, we couldn’t have created a mess of this magnitude. On the other hand, monetary officials understand from advances in knowledge in recent decades that providing liquidity and the ability to accommodate risk are absolutely essential, no matter how explosive the rhetorical sound bytes to the contrary. Armed with that wisdom, we will come through this situation as a strong and vibrant economy despite the horrific headlines. After all, there are still tulips in the Netherlands.