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Friday, December 08, 2006

Greenspan's Irrational Exuberance and Asset Price Targeting

John Berry looks at a topic addressed here a few days ago, an evaluation of Fed policy in light of Alan Greenspan's use of the phrase ''irrational exuberance,'' i.e. whether the Fed should target asset price bubbles. He argues that Greenspan may not have even been referring to the US stock market when he uttered this phrase, it was intended more generally, but in any case it was and is clear that Greenspan did not favor or suggest asset-price targeting:

'Irrational Exuberance' Baffles 10 Years Later, by John M. Berry, Bloomberg: Ten years ago this week, Alan Greenspan ... slipped the phrase ''irrational exuberance'' into an otherwise unremarkable long speech... His use of the phrase triggered a debate about the role of asset prices in monetary policy decisions that has never ended.

In December 1996, the asset prices in question were those of equities. Many of Greenspan's critics later complained that after having raised the issue of a possible stock price bubble, he and his Fed colleagues didn't do enough to deflate it before its bursting led to the 2001 recession.

The same complaints about Greenspan ... and his refusal to deal with asset price bubbles also are being heard now regarding housing prices. ...

However, even as he described how ''irrational exuberance'' could cause asset prices to climb rapidly, and perhaps add to inflationary pressures, Greenspan never suggested central banks should try to prevent a bubble from developing. Rather, if one did, he said, a central bank should only stand ready to limit the damage that might be done to the broader economy if the bubble burst.

In the December 1996 speech ..., the Fed chairman's use of the ''irrational exuberance'' phrase was so subtle that it was far from clear that he even had the U.S. stock market in mind.

''But where do we draw the line on what prices matter?'' he asked. ''Certainly prices of goods and services now being produced -- our basic measure of inflation -- matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?'' 

Sustained low inflation, of course, reduces risk and therefore ought to lead to higher asset prices, he said. ''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?'' he asked.

That was hardly a declaration that the Fed was so seriously worried about the level of stock prices that it was going to tighten monetary policy to prick whatever bubble may have been developing. ...

Furthermore, Greenspan's next words were: ''And how do we factor that assessment into monetary policy? We, as central bankers, need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy ... and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.'' ...

[T]he Japanese press overnight jumped on the story, drawing the conclusion that the Fed chairman was hinting at rate increases to curb rising stock prices. The next morning a Post editor called me at home to ask if that interpretation was right and would I try to get someone at the Fed to confirm one way or the other.

I said I was sure the Japanese press was wrong, though I would check. I reached a top Fed staff member who had seen drafts of the speech, and he and two other senior staff members with him at the time all agreed: No, the chairman's comment had nothing to do with U.S. stock prices.

Later that morning I heard again from the staff member I had called. He said he had mentioned to Greenspan the assurance the trio had given me, and the chairman said, ''You had better call him back.'' The stock market reacted the day following the speech, it declining only slightly, and then began again to forge new highs.

In congressional testimony the following February, Greenspan expanded on his ''irrational exuberance'' comments. Analysts' projections of profit growth needed to justify the high level of stock prices would be validated only if productivity growth accelerated and increases in compensation did not, he said.

''Neither, of course, can be ruled out,'' Greenspan said in a context that made it clear he didn't really expect that to happen. Of course, it did.

Princeton University economics professor Burton G. Malkiel, author of the widely read book, ''A Random Walk Down Wall Street,'' said during a seminar at the university in April 2005, that when Greenspan caused a stir by mentioning ''irrational exuberance'' there was no bubble in stock prices.

And he and others at the seminar, including several present and former Fed officials, all agreed that the central bank should not try to target the prices of equities, homes or other assets.

That's the correct view, though the debate Greenspan sparked a decade ago has by no means ended.

As I noted the last time this came up in the discussion of Jeremy Siegel's claim that there was no  bubble at the time of Greenspan's speech, that's my view as well - the Fed should focus on the broader economy and not target any specific sector.

    Posted by on Friday, December 8, 2006 at 09:30 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (1)  Comments (3)


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