“The concept of irrational exuberance came to me in the bathtub one morning,” Alan Greenspan recalled.
On Dec. 5, 1996, in what became a famous speech at the American Enterprise Institute, the then-Federal Reserve chairman implied that the stock market was suffering from “irrational exuberance.” To be precise, Greenspan put it in the form of a reasonable question:
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?”
“I was choosing my words very carefully,” he later wrote, and “I carefully hedged what I had to say in my usual Fedspeak.” But the audience and the press got the message that he was worried that stock prices were too high.
Greenspan didn’t answer his own question about how we can know when they are. It is indeed a hard one to answer, especially the timing, and lots of intelligent people get it wrong: otherwise market prices could not be so high at bubble peaks. The unexpected contraction of prices must be generally unexpected, otherwise it would already have happened.
And who is the “we” in Greenspan’s question? The Federal Reserve? It is obvious that the Fed does not know the answer any better than other people. Then-Treasury Secretary Robert Rubin had previously warned Greenspan not to talk publicly about stock market prices. Such comments, Rubin thought, were “likely to backfire and hurt your credibility”—as indeed happened with the AEI speech: “People will realize you don’t know any more than anybody else.” In my view, it is very good for people to realize this.
Were stock prices too high in December 1996?
The exuberance of the decade was the tech stock boom which became, as we know in retrospect, a vastly inflated bubble. Let’s put Greenspan’s speech in the context of the inflation-adjusted NASDAQ stock price index, expressed in constant 2000 dollars, as is shown in Graph 1.
When Greenspan gave the speech at AEI, this inflation-adjusted index was 1,392, or almost three times as high as the 486 it had been at the end of 1987, his first year in office. That is an average compound annual growth rate of more than 12 percent over nine years—already quite a remarkable run and not sustainable for the long term.
But after the speech, to Greenspan’s embarrassment, the market continued its rapid ascent for three more years. By the end of 1999, the inflation-adjusted NASDAQ index was 4,106—three times higher than when Greenspan had issued his warning. At that point, the speech looked pretty bad, to say the least.
A few months after that, however, came the top of the market, which had undoubtedly become irrationally very exuberant, then a rapid fall in prices, a dead cat bounce and then a market collapse. By September 2001, about five years after the speech, real prices were back to where they had been in December 1996. In other words, the inflation-adjusted price gain over nearly five years had been zero. The speech didn’t look too bad when viewed in retrospect from that point.
Nonetheless, it had been too early and had backfired as Rubin had predicted. The perfect timing, we can now see, would have been about two years later than the actual speech, at the end of November 1998. Then the warning would have nicely caught the final blow-off and the collapse. When Greenspan retired from the Fed in 2006, the total real price return from a November 1998 warning to his retirement date nine years later would have been zero. But when it comes to timing in particular, as well as to future asset prices in general, we are all in the realm of uncertainty.
Graph 2 brings the story up to the present.
In February 2009, three years after Greenspan had left the Fed, more than 12 years after his irrational exuberance speech, and in the midst of financial crisis, the real NASDAQ index was 21 percent below its level at the time of the speech. Since then, of course, a remarkable new boom has taken off and the index has just about regained its bubble peak.
From February 2009 to now, the real NASDAQ index has increased from 1,103 to 4,309, or by a multiple of about four times. The average compound price increase is more than 17 percent per year. Is this irrational exuberance? Or is it principally the effect of artificially low interest rates manufactured by Greenspan’s central banking successors?
On July 31, 2017, Greenspan issued a new bubble warning, and one less carefully worded and hedged: “By any measure, real long-term interest rates are much too low and therefore unsustainable,” he said in a press interview. “Long-term interest rates will rise” and “That is not good for asset prices.”
It seems to me that this is directionally correct. Will Greenspan’s timing prove to be better this time than last?
Image by Rob Crandall