By Peter C. Earle
Thirty years ago, Alan Greenspan delivered what may be the most famous rhetorical question in the history of the intersection of central banking and financial markets. Speaking at a black-tie dinner in Washington, DC, on December 5, 1996, the Federal Reserve chairman wondered aloud how policymakers could know when“ irrational exuberance” had driven asset prices to unsustainable heights. It was one question in a lengthy, characteristically dense address about central banking in a democratic society. Yet those two words escaped their enclosure, raced around the world, rattled financial markets and eventually became the name of an era. They resurface periodically to this day.
The phrase was memorable partly because Greenspan was not. At least his language was not supposed to be. He had cultivated a style so opaque that listeners joked about“ Greenspeak,” a dialect in which simple thoughts disappeared beneath subordinate clauses, qualifications and technical abstractions. Greenspan once quipped that if he appeared unusually clear, he must have been misunderstood. Financial journalists nevertheless parsed every adjective, pause and raised eyebrow because the man speaking them controlled the most important short-term interest rate in the world.
The setting was the American Enterprise Institute’ s annual dinner and Francis Boyer Lecture. Greenspan’ s address was titled“ The Challenge of Central Banking in a Democratic Society,” not“ Why the Stock Market Is a Bubble.” Most of it concerned the remarkable improvement in American monetary policy since the inflationary disasters of the 1970s. Central bankers, Greenspan argued, had learned that monetary expansion could not permanently increase employment or prosperity. At best, it could produce a temporary burst of activity followed by inflation and instability.
That was an important message in its own right. The United States was enjoying low inflation, falling unemployment, rapid technological change and strong economic growth. The expansion that had begun in 1991 was becoming one of the
Alan Greenspan, former chairman of the Federal Reserve, delivered his now famous“ Irrational Exuberance” speech 30 years ago. longest in US history. The Soviet Union had disappeared, personal computers were spreading, the commercial internet was emerging and American companies seemed to have discovered new ways to increase productivity. The national mood was not merely optimistic. It was becoming convinced that optimism itself was economically justified.
The stock market reflected that confidence. The Dow Jones Industrial Average stood near 6,400, having risen dramatically during the preceding years. The S & P 500 returned almost 38 % in 1995 and another 23 % in 1996. Investors were beginning to hear that new technology had invalidated old valuation standards. Companies connected to the internet could be valued by visitors, subscribers or“ eyeballs” rather than earnings. Profit was something that might arrive later, after market share, brand recognition and venture capital had done the important work.
Greenspan did not declare that stocks were overvalued. Instead, he asked how central bankers could know when irrational enthusiasm had inflated prices and how such a judgment should enter monetary policy. He then supplied the qualification that would define the official response to bubbles for years afterward: central banks need not worry about a collapsing asset boom unless it threatened production, employment or price stability. The question was daring, but the implied policy was cautious.
Markets initially heard only the daring part. Because Greenspan spoke in the evening in Washington, Asian markets were open. Stocks fell in Tokyo, Hong Kong and elsewhere before the reaction moved through Europe and back to the United States. Traders treated the phrase as a warning that the Federal Reserve might raise interest rates to restrain the market. Yet the panic was brief. American stocks recovered, and the great technology boom continued for more than three years.
That subsequent rise turned Greenspan’ s observation into both a brilliant warning and an apparent mistake. The Dow crossed 7,000, then 8,000, then 10,000. The S & P 500 approximately doubled between the speech and its 2000 peak. Nasdaq became the main theater of speculation, rising 86 % in 1999 alone before reaching 5,048 on March 10, 2000. Companies with no profits, little revenue and sometimes barely a product acquired multibillion-dollar valuations.
Pets. com became famous for a sock puppet mascot and infamous for proving that a memorable advertisement is not a business model.
If Greenspan was right, he was spectacularly early. That is usually indistinguishable from being wrong in financial markets. Anyone who sold stocks immediately after the speech missed years of enormous gains. A trader who bet aggressively against the boom could have been bankrupted long before the market finally vindicated his analysis. Markets can remain detached from reasonable valuation for an astonishingly long time because rising prices generate their own evidence. Every new high appears to prove that the skeptics did not understand the new world.
That is the essence of irrational exuberance. It does not require investors to become clinically irrational or wholly ignorant of fundamentals. It requires a social process in which rising prices strengthen the stories used to justify those prices. Early investors make money, attracting new investors who push prices higher. Financial media supply explanations for the gains, analysts raise their targets and entrepreneurs create companies designed to satisfy the demand for fashionable investments. What began as a plausible insight becomes an unquestionable doctrine.
The internet was certainly transformative. That point is essential because bubbles are rarely constructed around completely imaginary developments. Railroads changed the 19th-century economy even though railroad speculation ruined thousands of investors. Radio revolutionized communication despite the collapse of many radio stocks. The internet eventually transformed commerce, advertising, entertainment, finance and daily life more completely than even many enthusiasts predicted. The error was not believing in the technology. It was assuming that every company bearing its label would capture the resulting wealth and that no price was too high for a genuine glimpse of the future.
When the reversal came, it was unforgiving. The Nasdaq fell roughly 77 % between its March 2000 peak and October 2002. Numerous internet companies disappeared, telecommunications firms collapsed under enormous debts and investors discovered that revenue could not be replaced indefinitely by publicity. The United States entered a recession in 2001, although the downturn was comparatively
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