What Is Irrational Exuberance?
Irrational exuberance refers to investor enthusiasm that drives asset prices higher than those assets' fundamentals justify. The term was popularized by former Fed chair Alan Greenspan in a 1996 speech, "The Challenge of Central Banking in a Democratic Society." The speech was given near the beginning of the 1990s dot-com bubble, a textbook example of irrational exuberance:
"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?"
- 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
Irrational exuberance is widespread and undue economic optimism. When investors start believing that the rise in prices in the recent past predicts the future, they are acting as if there is no uncertainty in the market, causing a positive feedback loop of ever-higher prices.
It is believed to be a problem because it can give rise to bubbles in asset prices. But, when the ultimately bubble bursts, investors quickly turn to panic selling, sometimes selling their assets for less than they're worth based on fundamentals. The panic that follows a bubble can spread to other asset classes, and can even cause a recession. The investors who get hit the hardest — the ones who are still all-in just before the correction — are the overconfident ones who are sure that the bull run will last forever. Trusting that a bull won't turn on you is a sure way to get yourself gored.
Alan Greenspan raised the question of whether central banks should address irrational exuberance via a preemptive tight monetary policy. He believed that central should raise interest rates when it appears that a speculative bubble is beginning to take shape.
Example: The Late 1990's Dotcom Bubble
Fed Chair Alan Greenspan warned the markets about their irrational exuberance on December 5, 1996. But he did not tighten monetary policy until the spring of 2000, after banks and brokerages had used the excess liquidity the Fed created in advance of the Y2K bug to fund internet stocks. Having poured gasoline on the fire, Greenspan had no choice but to burst the bubble.
The stock market crash that followed erased more than four years of gains in the tech-heavy Nasdaq composite index and wiped out many billions of dollars in market capitalization.
Irrational Exuberance, The Book
Irrational Exuberance is also the name of a 2000 book authored by economist Robert Shiller. The book analyzes the broader stock market boom that lasted from 1982 through the dotcom years. Shiller's book presents 12 factors that created this boom and suggests policy changes for better managing irrational exuberance. The book's second edition, published in 2005, warns of the housing bubble burst which ended up occurring three years later in 2008, and led to the Great Recession.