Rational Exuberance and the Greenspan Fed

Jeremy Siegel says monetary policy after Alan Greenspan's "irrational exuberance" speech in 1996 was correct, there was no asset price bubble and therefore no need to deflate it:

Irrational Exuberance, Reconsidered, by Jeremy J. Siegel, Commentary, WSJ: Ten years ago yesterday, Alan Greenspan made what was to become [his] most famous speech... Against a backdrop of a strong economy and soaring stock market, Mr. Greenspan said: "How do we know when irrational exuberance has unduly escalated asset values? . . ."

Stocks indeed were surging when Mr. Greenspan spoke at the ... the American Enterprise Institute... Many economists claimed that the market was already too high, and some maintained that if the central bank didn't step in and cool the market, a subsequent crash could cripple the economy.

The Fed chairman's speech seemed to agree with those fearful of the soaring market. His words sent shock waves through the world's financial markets. Stock prices slumped world-wide ... when the market opened the next morning. But in the ensuing months, stocks continued to rise and the Fed did little to stop the bull market. Mr. Greenspan seemed to back away from his earlier statements, noting that the surprisingly strong growth in productivity and corporate profits may indeed justify higher stock prices.

After the market broke downward in 2001 and 2002, economists criticized Mr. Greenspan's inaction during the bull market, arguing that if he had stuck to his guns, the U.S. would have avoided the bubble in both the stock market and its economic fallout. The Economist magazine was particularly vocal in its criticism, asserting in a 2002 lead editorial, "If the Fed had popped America's bubble sooner, its economy would be healthier . . . Ironically, Mr. Greenspan was among the first to give warning of a bubble in 1996, drawing attention to the market's 'irrational exuberance.' What a pity he failed to put America's monetary policy where his mouth (briefly) was." ...

Should Mr. Greenspan have acted against the rising stock market when he made his famous "irrational exuberance" speech?

Now that we have 10 years of economic and financial data, we can now accurately determine whether the market was indeed "irrationally exuberant" in December 1996. The answer is decidedly no. Had the market been overvalued, it would have shown poor return in the following decade. But it did not. ...

So what happened to the stock bubble? In fact, the data show it did not start until late 1998, two years after Mr. Greenspan's warning of "irrational exuberance." And the exuberance was entirely concentrated in the technology sector...

The evidence also shows that non-tech stocks were never in a bubble, neither in 1996 nor when the S&P 500 Index reached its peak in March 2000. If one takes tech and the tech-related telecom stocks out of the S&P 500, the remaining stocks were actually depressed when the tech stocks hit their peak. ...

Looking back in August 2002, Mr. Greenspan was perfectly right when he said, at the annual Kansas City Fed economic conference in Jackson Hole, that "Historical data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion." Had the Fed tightened further in late 1999 or early 2000, there would be little doubt that "brick and mortar" firms, as the non-tech stocks were called, would have borne the brunt of the tightening and pushed their valuations even lower. The subsequent recession when the tech bubble finally burst would have been far worse.

History has exonerated Alan Greenspan's policy during the late 1990s. There is no good evidence that the market was in a bubble when he uttered his famous line 10 years ago, and he was wise in stepping back from it. Irrational exuberance finally did hit the stock market, but not at the time or in the scope envisioned by his critics.

By this reasoning, there's a mistake somewhere in any case. If Greenspan was correct about stocks being overvalued, then following the presumption in the article that the Fed would and should target asset price bubbles (they have said they won't), monetary policy was incorrect and should have been tightened. If Greenspan was wrong about stocks being overvalued, then monetary policy was justified relative to the asset price targeting assumption.

But I don't buy the presumption that asset prices ought to be the focus of monetary policy, except to the extent that there is spillover to the larger economy, so the metric used here for evaluating policy -- whether or not an asset bubble should have been deflated with monetary policy -- is not one I agree with. Taking the economy as a whole into account, I don't see reason to criticize monetary policy decisions made by the Fed during that time period. There are certainly those who disagree.