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More than at any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness, the other to total extinction. Let us pray we have the wisdom to choose correctly. – Woody Allen

In November of 1636 you could buy a small townhouse in Amsterdam, Holland for about 300 gold florins. That sum represented about a year’s income for a typical Dutch family. That same year single bulbs of the most prized varieties of tulips sold for over 5,000 florins. So valuable were they that their weight was expressed in “perits,” a unit smaller than the English grain, which is one seven thousandth of an ounce.

Tulip exchanges sprang up alongside stock exchanges in every major city in Holland and eventually in London and Paris. An elaborate financial system serviced a wild speculation in what were essentially fancy onions. The tulip craze spawned the most sophisticated system of paper finance the world had ever seen. It included a brisk trade in options, futures and other derivative paper tools of finance. For it’s time it was no less impressive, although much smaller, than our modern worldwide trade in paper promises. Much of today’s most prized paper wealth is backed, not by tulips, but by patches of dirt, piles of bricks or by politicians who pledge to fleece their constituents.

The craze for tulips spread from those wealthy enough to afford silly self-indulgence down through society to the sailors, merchants, mechanics, chimney sweeps and servants who clearly could not afford to gamble their life’s savings on a single exotic onion.

A recent front page news story reminded me of the 17th century tulip bubble. The story was of a waitress who had just cut her living space by half and more than doubled her monthly housing expense to buy a 400 square foot studio apartment. She took on an adjustable rate mortgage that, according to a local loan officer, will consume half her income. The banker seemed as unconcerned about getting the bank’s money back as the woman was about rising interest rates.

The waitress said she considered her cripplingly expensive living arrangement “an investment.” “If worse comes to worst,” she said, “I can always sell it.” Of course she can. The only question is will she be able to sell it for at least what she paid for it plus her transaction costs plus the extra spent on rent, taxes and insurance while living there? If not, her “investment” will be a ruinous hardship.

Sadly, this home buyer, like many home buyers, doesn’t understand the difference between investment and speculation. In the short run she is measurably poorer for having made her investment. She is counting on salvation in the long run and a continuation of last year’s historic 40% increase in condo prices to make her investment pay. Will it pay? The future is unknowable. That’s part of the fun. One thing is certain however, what the woman believes is an investment is in fact a highly leveraged speculation.

In a healthy economy, speculators are a tiny percentage of the market. They are expert risk takers who lubricate markets at the margins, like the bacteria in a healthy gut. The health of an economy fades as the number of speculators increases, just as our health would fade if our bodies were overwhelmed by an explosion in the number of normally benign bugs dwelling in our digestive tracts.

The real estate market today, like the tulip market of 1636 consists entirely of speculators. Investors analyze their investment purchases to determine value, expecting a return on productive enterprise. Speculators are simply gamblers who bet on the rise and fall of prices.
By every practical measure, a home is not a productive investment. On the contrary, housing is a consumer good. A house is a pile of termite food held together by nails that rust, kept dry by roofing that wears out, coated with paint that eventually fades away. A house produces nothing but shelter for its occupant. Shelter costs money. It doesn’t earn money.

The “wealth” created by housing is an illusion produced by credit expansion. Paper “equity” borrowed out of homes doesn’t build any factories, grow any food or pay off any more debt than it creates. Mr. Greenspan recklessly added seats to a national game of musical chairs by lowering interest rates to less than inflation rates. Who could resist joining a game of musical chairs where there’s always a place to sit? But lately the world’s most famous bureaucrat has been steadily raising rates, removing chairs from the game. He’s even warned us that he plans to stop the music, declaring that anyone who has not by now hedged his position against rising interest rates clearly wants to lose money.

By the end of 1637 the music had stopped in Holland. The normally sensible Dutch had regained their senses. In a few months prices for tulip bulbs plunged to less than 10% of what they had been. The Dutch courts refused to enforce contracts made for “gambling debts.” Today you can buy six sprouted tulip bulbs in a pot complete with dirt for less than $30. At least an apartment will never be worth less than the shelter it provides.