Irrational Exuberance

The phrase irrational exuberance refers to the systematically excessive valuation of financial assets by investors, which is a function of wishful thinking and reflected in unjustifiably high market price levels. Alan Greenspan, then Federal Reserve Board Chairman, coined the phrase in a speech to the American Enterprise Institute in December 1996 in the context of the “new economy” boom of the late 1990s. Strangely, it was buried within the speech as a rhetorical question about how we can know when asset prices are distorted above justifiable values. Ironically, the immediate and negative reaction within the markets ensured the phrase was remembered.

The most systematic treatment of the phenomenon has been by Robert Shiller, professor of economics at Yale. His book Irrational Exuberance was rushed into press as the NASDAQ stock market peaked in March 2000. The aim of Shiller's book was not to predict the bursting of the bubble, but instead to identify the longer-term costs of the bubble bursting when it did. Shiller argued that there were a number of precipitating factors (such as, inter alia, the Internet and day-trading and sports-style media coverage) that helped drive up stock prices and were then amplified by positive feedback mechanisms, chief among which was the media. The irrationality of aggregate price levels notwithstanding, Shiller acknowledged the individual rationality of free-riding rising prices. Shiller's book, though taking the dot-com bubble as its point of departure, is a more general thesis on market bubbles in the tradition of Charles Kindleberger's classic work, Manias, Panics and Crashes: A History of Financial Crises.

Appropriate governance measures hinge on, one, whether the market is appropriately valued and, two, whether the exuberance affects the “real economy.” If irrational exuberance is present, then monetary policy is an important tool in dampening speculative bubbles; an increase in interest rates can be useful in restraining continuing exuberance. Transactions taxes have also been proposed to discourage short-term speculation and encourage long-term investment based on the rational assessment of economic fundamentals. In contrast to these reregulative measures, others have argued that only increasing the amount of trading carried out in the markets will prove successful because this will truly free market forces to enforce a rational equilibrium.

Greenspan, in his initial speech, suggested that if the exuberance did not affect production, jobs, and price stability, that is, the real economy, then it should not concern policymakers. Unfortunately, when the bubble bursts, those who have used the stock market as an investment vehicle are badly hurt. With more than two-thirds of savings in 401(k) pension plans invested in the stock market, Shiller's argument is that damage is accentuated by the excessive dependence on stock investment. Governance initiatives should therefore guide employees toward diversifying into relatively riskless investments, say, inflation-linked bonds; Shiller stresses the importance of public opinion leaders in this process. Similarly, initiatives to invest public social security funds into the stock market should be resisted because they provide an important national risk-sharing function.

The problems of irrational exuberance are not just limited to the aftermath. Although it may appear that everyone gains during the expansion phase of a bubble—firms, management, employees, and the share-holding public—there are serious and negative consequences for the efficient allocation of resources. If capital is increasingly channeled into the booming stock market in search of quicker and higher returns, then other potentially productive sectors are left undercapitalized, and investment decisions are neither socially desirable nor best for all investment sectors.

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