We are approaching the 20th anniversary of Alan Greenspan’s famous ‘irrational exuberance’ speech. Many remember those two words but few remember their context:
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past.
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? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability.
Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.
In December of 1996, Greenspan was clearly beginning to worry about the economic fallout of a bursting asset bubble. Back then he had a front row seat and, in fact, a strong hand in creating the dotcom bubble, whether he admits it or not. He was so worried about the consequences of ‘irrational exuberance’ that he declared these concerns ‘must be an integral part of the development of monetary policy.’ And this was before he had even witnessed any of the actual economic consequences we have now lived with for two decades. Clearly, his worries were well founded but he wasn’t quite worried enough.
This post was published at Wall Street Examiner by Jesse Felder ‘ October 20, 2016.