What Is Irrational Exuberance?
Let me explain irrational exuberance to you: it's that investor enthusiasm that pushes asset prices way higher than what the fundamentals actually support. I remember how former Fed chair Alan Greenspan made this term famous in his 1996 speech, 'The Challenge of Central Banking in a Democratic Society.' He gave that talk right at the start of the 1990s dot-com bubble, which is a classic case of this phenomenon.
In his words: '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? And how do we factor that assessment into monetary policy?'
Key Takeaways
- Irrational exuberance is unfounded market optimism that lacks a real foundation of fundamental valuation, but instead rests on psychological factors.
- The term was popularized by former Fed chair Alan Greenspan in a 1996 speech addressing the burgeoning internet bubble in the stock market.
- Irrational exuberance has become synonymous with the creation of inflated asset prices associated with bubbles, which ultimately pop and can lead to market panic.
Breaking Down Irrational Exuberance
You need to understand that irrational exuberance is this widespread and undue economic optimism. When investors start believing that recent price rises predict the future, they're acting like there's no uncertainty in the market, which creates a positive feedback loop of ever-higher prices.
This is a problem because it leads to bubbles in asset prices. But when the bubble bursts, investors panic and sell, sometimes at prices below what the fundamentals justify. That panic can spread to other assets and even cause a recession. The ones hit hardest are the overconfident investors who stay all-in right before the correction, thinking the bull run will last forever. Trust me, assuming a bull market won't turn on you is a sure path to getting hurt.
Alan Greenspan raised the issue of whether central banks should tackle irrational exuberance with preemptive tight monetary policy. He thought they should raise interest rates when a speculative bubble starts forming.
Example: The Late 1990s Dotcom Bubble
Take the late 1990s dot-com bubble as an example. Fed Chair Alan Greenspan warned about irrational exuberance on December 5, 1996. But he didn't tighten policy until spring 2000, after banks and brokerages used the extra liquidity from Y2K preparations to fund internet stocks. It was like pouring gasoline on a fire, and Greenspan had to burst the bubble.
The resulting stock market crash wiped out more than four years of gains in the tech-heavy Nasdaq composite index and erased billions in market capitalization.
Irrational Exuberance, The Book
There's also a book called 'Irrational Exuberance' by economist Robert Shiller, published in 2000. It analyzes the stock market boom from 1982 through the dot-com years. Shiller identifies 12 factors behind this boom and suggests policy changes to manage irrational exuberance better. The second edition in 2005 warned about the housing bubble, which burst in 2008 and led to the Great Recession.
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