In 1996, then-Federal Reserve Chairman Alan Greenspan gave a speech titled "The Challenge of Central Banking in a Democratic Society." Greenspan coined the term "irrational exuberance" to describe a phenomenon of market excitement driving asset prices higher than fundamentals might support.

Twenty years later, many pundits worry that irrational exuberance is driving more asset bubbles. Some disagree, trusting the market to be priced efficiently. Others wonder why economists and policymakers cannot prevent, or even spot, most asset bubbles before they become dangerous. Greenspan himself is often accused of inflating bubbles during the 1990s and 2000s, and some evidence suggests there may be some truth to this belief. Even if economists and the Fed chairperson struggle to identify them, there are plausible reasons to explain why asset bubbles last so long.

Asset Bubbles Have Psychological Roots

Greenspan originated the popular use of "irrational exuberance," though, in 2016, the term is more commonly associated with Yale economist Robert J. Shiller. A recipient of the 2013 Nobel Prize in economics, Shiller authored a book, fittingly titled "Irrational Exuberance," in which he asserts that psychologically driven volatility is an inherent characteristic of asset markets. The first edition of Shiller's book warned of the tech bubble in 2000. The second edition, published in 2005, warned about unusually high real estate prices. Each proved prescient.

Shiller's view draws deeply from economists John Hicks and Vilfredo Pareto, who famously developed a theory of optimal resource distribution according to what he perceived to be the logical limits of exchange. Shiller claims investors fail to reach Pareto efficiency due to flaws in human psychology.

The premise of Shiller's work on asset bubbles has been long accepted by economists; demand for an asset becomes detached from fundamental factors and appears to be built on rapid increases in market value. Shiller goes into even more detail, arguing these rising assets are fueled by a frenzied media. He highlights a tendency for the general public to fall victim to new theories that justify unprecedented asset prices.

Asset Bubbles Are Probably Rational, Not Irrational

Shiller is also an advocate of behavioral finance, the soft form of which proposes that real economic actors do not act like the agents in Marshallian economic models. Instead, people have emotions and impulses and incomplete information, none of which are accounted for in perfect equilibrium economics.

The hard form of behavioral finance theory suggests people are deeply irrational, in an economic sense, and government regulation is required to moderate irrational investor activity. Shiller has at least one foot in this camp.

There is one major problem with this view. There is an explanation for why investors might rationally purchase a rising asset. Shiller is right that perfect equilibrium microeconomics cannot explain asset bubbles, but bubbles might be explained by combining three other classic postulates: the law of demand, opportunity costs and the subjective theory of value. And these help explain why exuberance can be so stubborn.

The Law of Demand and Opportunity Costs Explain Asset Bubbles

The law of demand in economics states that, all else being equal, the demand for a product increases as its cost decreases. Asset bubbles appear to violate this law; consider homebuyers who bought record numbers of houses between 2002 and 2007 despite record home prices.

It is not really true that home costs were increasing, at least in an economic sense. Market values rose significantly during the period, but economists know the only true costs are opportunity costs, and the opportunity cost of not buying a home was extremely high in 2005. Homes could be flipped and resold for great profit. Owners could use a home equity line of credit (HELOC) for cheap credit. A $300,000 home is not that expensive when you expect it to sell for $500,000 in 18 months.

All economic value is subjective, driven by the unique perceptions of each individual in a transaction. If a tech stock shows a strong upward trajectory, an investor is not irrational if she values it at more than its current market price. She clearly expects the stock to generate more capital gains or dividends down the road. The real mystery, and ultimately the reason most asset bubbles last, is why certain asset markets tend to spike randomly in the first place.

"Speculators might respond rationally," says Dr. George Selgin, senior fellow and director at the Center for Monetary and Financial Alternatives, "if interest rate reductions look like changes to fundamental asset-price determinants." In other words, there is no real dichotomy between fundamentals and asset bubbles. There is only a dichotomy between real market signals and artificial signals.

Artificially Low Interest Rates Often Spark and Maintain Bubbles

Historically, large asset bubbles in the United States have formed after periods of unusually low interest rates. This was true before the stock market bubble of the late 1920s, the dot-com bubble of the late 1990s and the housing bubble of the mid-2000s.

These are cases of policymaker psychology creating bubbles, particularly out of fear of deflation or recession. Low interest rates encourage borrowing by making credit cheap. They also punish traditional savers, so individuals and companies must be more speculative in order to earn returns. More people enter the asset markets than would have otherwise occurred.

Businesses thrive superficially on artificially low rates. Since financing is less risky, internal rates of return seem more promising and longer-term projects appear more profitable. So firms expand and capital projects are undertaken. If future savings are not sufficient enough to consume all of this future business product, once-profitable companies are forced to cut back, which could pop a bubble.

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