Irrational exuberance refers to investor enthusiasm that drives asset prices higher than their underlying fundamentals justify. Coined by former Federal Reserve Chairman Alan Greenspan in a 1996 speech, the term became synonymous with bubbles in asset prices that eventually burst, leading to significant market declines.
Key Insights
- Irrational Exuberance Defined: Investor optimism that lacks a real foundation of valuation metrics, instead driven by psychological factors like herd mentality.
- Roots of the Term: Alan Greenspan popularized the concept in a speech that predated the dotcom bubble of the late 1990s.
- Consequences: Irrational exuberance often leads to inflated asset prices and subsequent market panics when the bubble bursts.
Understanding Irrational Exuberance
Positive Feedback Loop
Irrational exuberance stems from widespread and undue economic optimism. When investors start believing that past price increases foretell future gains, they ignore market uncertainties and enhance asset prices in a positive feedback loop. This creates a cycle of rising prices detached from asset fundamentals.
The Risk of Bubbles
This behavior can give rise to bubbles in asset prices. As the bubble inflates, it becomes more unsustainable, leading to an inevitable burst. When this occurs, investors may panic sell, often offloading assets at prices far below their fundamental value. Such panic can spill over into other asset classes and potentially lead to a recession.
Central Banking Responses
Greenspan pondered whether central banks should counter irrational exuberance by tightening monetary policy preemptively. By raising interest rates at the advent of speculative bubbles, central banks could potentially mitigate irrational investment behaviors.
Real-Life Example: The Dotcom Bubble
In December 1996, Greenspan warned the markets about their irrational exuberance but did not act immediately. By the spring of 2000, the Federal Reserve had to tighten monetary policy due to the exuberant funding of internet stocks, which eventually led to the burst of the dotcom bubble.
The subsequent stock market crash wiped out over four years of gains in the tech-heavy Nasdaq, erasing billions of dollars in market capitalization.
Further Reading: Irrational Exuberance by Robert Shiller
Economist Robert Shiller’s book, Irrational Exuberance, delves into the stock market boom from 1982 through the dotcom bubble. Shiller identifies twelve factors contributing to the boom and suggests policy changes for managing irrational exuberance. In its second edition published in 2005, Shiller also accurately forecasted the 2008 housing bubble burst and the ensuing Great Recession.
Take a closer look at how irrational exuberance affects financial markets and the broader economy by exploring these concepts and real-world examples.
Related Terms: Market Bubble, Positive Feedback Loop, Panic Selling, Investor Behavior, Monetary Policy.
References
- Federal Reserve System. “The Challenge of Central Banking in a Democratic Society”.
- Robert J. Shiller. “Irrational Exuberance: Revised and Expanded Third Edition”. Princeton University Press, 2016.
