Author Les Leopold (The Looting of America: How Wall Street’s Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity—and What We Can Do About It) reminds us that the housing bubble and the Wall Street collapse weren’t rare, or new, occurrences in the history of finance. Booms and busts have been happening for hundreds of years—and it seems we never learn.

The following is an excerpt from The Looting of America: How Wall Street’s Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity—and What We Can Do About It by Les Leopold. It has been adapted for the Web.

Long before there was Wall Street, there was the bubble. Something about the financial market seems to encourage financial booms, which lead to bubbles, which lead to debilitating financial collapses. Only the blindest ideologue could ignore the historical connection between financial panics and “free” financial markets. When left to their own devices, financial markets always melt down, eventually. (Scholars have counted 148 meltdowns since 1870 where a country’s economy has shrunk by 10 percent or more. They also found 87 instances where per-person consumption dropped by that amount. On average the size of the drop was 21 to 22 percent and lasted three and a half years.¹⁵)

The first sizable bubble and bust involved the tulip-loving Dutch during the 1630s, a time of commercial success and relative peace. Thriving regional trade had enabled Dutch merchants to accumulate significant wealth and enough surplus income to indulge in conspicuous consumption. The Dutch adored rare varieties of tulips for their beauty and because they advertised the wealth of those who possessed them. According to financial historian Edward Chancellor, “In 1624, a Semper Augustus¹⁶ fetched the handsome sum of 1,200 florins, an amount sufficient to purchase a small Amsterdam town house.”¹⁷ Soon nearly all tulip varieties were in high demand, generating a vibrant tuliptrading market. But this was not your typical floral market. Since tulips could only be grown at certain times of the year, the market developed contracts for future delivery, secured by borrowed money. As a result, “most transactions were for tulip bulbs that could never be delivered because they didn’t exist and were paid for with credit notes that could never be honored because the money wasn’t there.”¹⁸ This practice of leveraging (buying stuff with lots of borrowed money) drove up prices to insane levels: One Viceroy tulip bulb was supposedly worth the equivalent of “twenty-seven tons of wheat, fifty tons of rye, four fat oxen, eight fat pigs, twelve fat sheep, two hogsheads of wine, four turns of beer, two tons of butter, three tons of cheese, a bed with linen, a wardrobe of clothes and a silver beaker.”¹⁹ As prices climbed, word spread, attracting more and more of the Dutch as well as foreign investors into the market—further inflating prices. For a short time it seemed that small and large fortunes came to those who bought and sold tulip contracts. Modest tradesmen got into the act by taking out loans against their homes and other assets. The casino was open for almost a year and it seemed that everyone came away a winner.

No one is sure why the crash came on that day, February 3, 1637. Prices plummeted so catastrophically that a year later a government commission had to unwind the tulip contracts altogether, declaring that each could be annulled on payment of only 3.5 percent of the agreed price. Although the Dutch economy did not collapse, a great many players were badly burned. The Dutch love of tulips turned to disgust.

We’ve had nearly four hundred years to absorb the lesson of this market bubble. And yet we haven’t. Obviously, we are prone to get-rich schemes. We move like a herd when the chase is on for items of apparent value. The more others move, the more we want in on the action. As share prices rocket upward, we want to get our piece, further driving up the price. Then, at the moment when the gap between the intrinsic worth of the item and reality stretches to the breaking point, the herd stampedes in the other direction. Prices reverse, leading to more selling, and an even more swooping decline. Because so much of the upside is fueled by borrowed money, the downside accelerates when the collateral for the loans—the shares that were bought—declines in value. Shares then must be sold to pay off the loans and a death spiral follows: declining share prices leads to more sales to repay loans, which leads to more declining prices. Nearly four centuries later, then Federal Reserve chairman Alan Greenspan called the upside “irrational exuberance.”²⁰

The Dutch Tulip Bubble was harmless compared to the bubbles that followed. England’s South Sea Bubble of 1720 more accurately foretold our financial future.

The South Sea Corporation was founded to conduct trade and to market much of the English national debt, which was until then held by wealthy citizens in the form of annuities.²¹ The corporation encouraged these rich annuity holders to convert their holdings into South Sea Corporation shares, which would pay dividends. In the process, the government’s debt would disappear, and a new secondary market would be created that would allow the wealthy annuity holders to unload their assets more readily. The new company cut a careful deal with the Bank of England: The higher the price of the shares, the higher the profits for the investors. In fact, higher share prices benefited the government by making it more tempting for annuity holders to convert their claims on the government into corporate shares. To grease the skids, many members of Parliament were given stock, as were various cabinet ministers. The stock soon became wildly popular, and the bubble began to expand. In only six months the stock’s value increased eight times its original price. The euphoria spread throughout the growing English capital market, leading to a profusion of new bubble companies seeking—and finding—investors for fraudulent ventures.

The South Sea corporate directors didn’t like all these imitators entering the frothing market in search of sterling and suckers. They wanted the government to tamp down the proliferation of these competing bubble companies by requiring all new shareholder corporations to get a government charter. The “Bubble Act” barred “the establishment of companies without parliamentary permission and prevented existing companies from carrying on activities not specified by their charters.”²² When this failed to suppress the bubble companies, the South Sea directors asked the attorney general to prosecute. They also increased the company’s guaranteed dividend to a whopping 50 percent per year for the next twelve years to get the attention of investors who were chasing after high returns in the boom market. The combination of government regulation plus the exorbitant dividend was supposed to further drive up stocks. Instead, the euphoric stock market crashed, taking down the South Sea enterprise with it. In four weeks the value of South Sea’s stock fell by 75 percent.

In the decades and centuries to come, such bubbles would form and burst again and again—from South American mines, to railroads, to the stock market bubble of the 1920s, to the crash of the Internet and housing bubbles in the early twenty-first century. Investors can’t help themselves, nor can the financial system as a whole. The key players always find ways to profit wildly by building the momentum and pumping up prices well past any reasonable value. The process of borrowing to buy more assets and the inflation of those asset prices reinforce each other. At some point, the gap between fantasy finance and reality stretches to the snapping point. And then comes the collapse. Sometimes, the underlying economy is strong and the impact is contained. At other times, the collapse sets off a deep depression that threatens the entire economy.

1. Robert J. Barro and José F. Ursúa, “Macroeconomic Crises since 1870,” Brookings Paper on Economic Activity, May 7, 2008, at http://www.econ.yale .edu/seminars/macro/mac08/Barro-081028.pdf.
2. “A Rosen, with blood-red flares or flames vividly streaked on a white ground, and flakes and flashes of the same color at the petals’ edge, Semper Augustus was, by all accounts, an extraordinary flower, and one celebrated at the time for its beauty and rarity.” From http://penelope.uchicago.edu/~grout/encyclopae dia_romana/aconite/semperaugustus.html.
3. Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation (New York: Plume Books, 2000), p. 16.
4. Ibid, p. 18.
5. Ibid, p. 19.
6. “Remarks by Chairman Alan Greenspan,” at the Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, D.C., December 5, 1996. “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” At www.federalreserve.gov/boarddocs/speeches/1996/ 19961205.htm. However, there are also powerful economic arguments that describe this process as part and parcel of financial markets—that you don’t need herd mentality or irrational exuberance to create a bubble. For example, economists John Maynard Keynes and later Hyman Minsky argued that capital markets were inherently unstable, even if we assume rational behavior on the part of the buyers and sellers in the markets. During the past thirty years many of their ideas were dismissed. But the crash of 2008 has brought renewed attention to their theories. We will return to their theories in the last chapters of this book.
7. Money was provided to the government in return for a fixed payment per year in perpetuity.
8. Chancellor, p. 82.

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