Economist's View: Rational Exuberance and the Greenspan Fed

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Jeremy Siegel says monetary policy after Alan Greenspan's "irrational exuberance" speech in 1996 was correct, there was no asset price bubble and therefore no need to deflate it:

Irrational Exuberance, Reconsidered, by Jeremy J. Siegel, Commentary, WSJ: Ten years ago yesterday, Alan Greenspan made what was to become [his] most famous speech... Against a backdrop of a strong economy and soaring stock market, Mr. Greenspan said: "How do we know when irrational exuberance has unduly escalated asset values? . . ."

Stocks indeed were surging when Mr. Greenspan spoke at the ... the American Enterprise Institute... Many economists claimed that the market was already too high, and some maintained that if the central bank didn't step in and cool the market, a subsequent crash could cripple the economy.

The Fed chairman's speech seemed to agree with those fearful of the soaring market. His words sent shock waves through the world's financial markets. Stock prices slumped world-wide ... when the market opened the next morning. But in the ensuing months, stocks continued to rise and the Fed did little to stop the bull market. Mr. Greenspan seemed to back away from his earlier statements, noting that the surprisingly strong growth in productivity and corporate profits may indeed justify higher stock prices.

After the market broke downward in 2001 and 2002, economists criticized Mr. Greenspan's inaction during the bull market, arguing that if he had stuck to his guns, the U.S. would have avoided the bubble in both the stock market and its economic fallout. The Economist magazine was particularly vocal in its criticism, asserting in a 2002 lead editorial, "If the Fed had popped America's bubble sooner, its economy would be healthier . . . Ironically, Mr. Greenspan was among the first to give warning of a bubble in 1996, drawing attention to the market's 'irrational exuberance.' What a pity he failed to put America's monetary policy where his mouth (briefly) was." ...

Should Mr. Greenspan have acted against the rising stock market when he made his famous "irrational exuberance" speech?

Now that we have 10 years of economic and financial data, we can now accurately determine whether the market was indeed "irrationally exuberant" in December 1996. The answer is decidedly no. Had the market been overvalued, it would have shown poor return in the following decade. But it did not. ...

So what happened to the stock bubble? In fact, the data show it did not start until late 1998, two years after Mr. Greenspan's warning of "irrational exuberance." And the exuberance was entirely concentrated in the technology sector...

The evidence also shows that non-tech stocks were never in a bubble, neither in 1996 nor when the S&P 500 Index reached its peak in March 2000. If one takes tech and the tech-related telecom stocks out of the S&P 500, the remaining stocks were actually depressed when the tech stocks hit their peak. ...

Looking back in August 2002, Mr. Greenspan was perfectly right when he said, at the annual Kansas City Fed economic conference in Jackson Hole, that "Historical data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion." Had the Fed tightened further in late 1999 or early 2000, there would be little doubt that "brick and mortar" firms, as the non-tech stocks were called, would have borne the brunt of the tightening and pushed their valuations even lower. The subsequent recession when the tech bubble finally burst would have been far worse.

History has exonerated Alan Greenspan's policy during the late 1990s. There is no good evidence that the market was in a bubble when he uttered his famous line 10 years ago, and he was wise in stepping back from it. Irrational exuberance finally did hit the stock market, but not at the time or in the scope envisioned by his critics.

By this reasoning, there's a mistake somewhere in any case. If Greenspan was correct about stocks being overvalued, then following the presumption in the article that the Fed would and should target asset price bubbles (they have said they won't), monetary policy was incorrect and should have been tightened. If Greenspan was wrong about stocks being overvalued, then monetary policy was justified relative to the asset price targeting assumption.

But I don't buy the presumption that asset prices ought to be the focus of monetary policy, except to the extent that there is spillover to the larger economy, so the metric used here for evaluating policy -- whether or not an asset bubble should have been deflated with monetary policy -- is not one I agree with. Taking the economy as a whole into account, I don't see reason to criticize monetary policy decisions made by the Fed during that time period. There are certainly those who disagree.

Posted by Mark Thoma on December 6, 2006 at 01:39 AM in Economics, Monetary Policy | Permalink

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Comments

I agree with you and Jeremy Siegel on all counts.

Posted by: spencer | Dec 6, 2006 5:31:30 AM

seems using monetary policy to deflate bubble is a dangerous game. some said that instead of hiking rates he should have increased stock margin requirements. not even sure if that is the feds call but derivatives make that hard to do.

i'd like to know how siegel comes to the conclusion that the s&p 500 was not in a bubble. what was his metric? after at least several years of record corp. profits, the index is not back to 2000 highs. maybe the argument is the market cap. of a few overvalued stocks in a cap weighted index is not a bubble.

Posted by: adam | Dec 6, 2006 6:21:54 AM

The problem is the FED's assymetric response to bubbles. When a bubble is inflating, it's either too difficult to recognize or ignored. When a bubble deflates, the fed drops interest rates and increases liquidity. It's called moral hazard, and AG ought to be able to recognize it.

Posted by: Idaho_Spud | Dec 6, 2006 6:51:16 AM

Here we have market returns over the last decade:

http://www.mscibarra.com/products/indices/us/performance.jsp
http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard MS Fund Returns
11/30/96 to 11/30/06

Large Cap Index is 7.6
Large Cap Growth Index is 5.2
Large Cap Value Index is 9.7

Mid Cap Index is 12.1
Mid Cap Value Index is 14.8

Small Cap Index is 12.1
Small Cap Value Index is 14.0

Europe Index is 10.7
Europe Value Index is 13.8
Pacific Index is 2.6
Pacific Value Index is 4.5
Emerging Markets Index is 8.8

Energy is 16.7
Health Care is 16.5
Precious Metals is 13.7
REIT Index is 15.6

Long Term Bond Index is 7.7
Intermediate Term Bond Index is 6.4

Posted by: anne | Dec 6, 2006 7:31:34 AM

Listening Robert Shiller a saver-investor would have stayed away from the stock market for the decade, and Shiller never gives any hint on how the bond market might be used as an alternative. Shiller was wrong, and wrong for a decade is wrong for life. A general domestic index investor has done fine over the last decade while an investor leaning to value, as should have been the case given relative prices on November 30, 1996, has done better than fine.

Long term bond index investors did fine for those who looked for more conservative positions than value and middle and small cap stocks.

Europe was fine. Only the Japanese market-of-death was a problem, and any investor with the slightest sense of value would have understood enough to stay away from Japan, though analysts love pricing absuridty.

Posted by: anne | Dec 6, 2006 7:42:12 AM

Notice that investors who simply indexed to the broad market have fared well over the decade as they have fared well before. Those who were paying attention to relative value and not to analysts, as a Warren Buffett has continually taught, have had an excellent decade, but that is not necessary for the ordinary investor. Vanguard indexing has been a simply wonderful tool for 30 years. The Vanguard S&P index is now 30 years old and has returned 12.2% over 30 years. Nice!

Posted by: anne | Dec 6, 2006 7:53:21 AM

http://www.mscibarra.com/products/indices/stdindex/performance.jsp

National Index Returns [Dollars]
12/1/96 - 12/1/06

Australia 12.3
Canada 13.1
Finland 17.4
France 11.6
Germany 9.2
Hong Kong 4.3
Japan 1.4
Netherlands 8.1
Norway 13.2
Sweden 12.5
Switzerland 11.1
UK 8.9
USA 7.9

National Index Returns [Domestic Currency]
12/1/96 - 12/1/06

Australia 12.6
Canada 11.3
Finland 17.0
France 10.9
Germany 8.7
Hong Kong 4.