Policy Makers and Irrational Exuberance

by Chidem Kurdas

Robert Shiller says the speculative bubble in real estate was driven by “a contagion of optimism” that pushed up prices and expectations in a feed-back loop. This epidemic apparently engulfed regulators as well.  “Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint,” he writes in a NYT column.

This is a plausible explanation of the psychological mechanism that operates in any bubble. It eventually collapsed and led to the property slump that underpins the current economic malaise And Professor Shiller is right that public officials are not immune. But federal entities breathing in heady fumes is different from anybody else breathing in the same.

After all, the federal government is uniquely big and powerful. Mr. Shiller ignores the institutional implications of this. The key question is,  Why should it be any different the next time around?

Consider that the property bubble followed the 1990s stock bubble. In December 1996, then Federal Reserve Chairman Alan Greenspan asked, “But how do we know when irrational exuberance has unduly escalated asset values?” Once that bubble burst, he argued that there is no way of knowing until it’s over.

But in 1998 the Fed further stoked the red-hot stock market by repeatedly adding to the money pipeline. This was in response to what looked like a crisis caused by Asian debt problems, a temporary default byRussia and the near-failure of hedge fund Long-Term Capital Management. In the early 2000s it did so again in response to the downturn.

Surely the Federal Reserve’s interventions threw the economy off track, as John Taylor has argued.  Optimism was fueled by the belief that the Fed would intervene to protect asset prices, an idea that came to be known as the Greenspan put. Meanwhile, Fannie and Freddie continued their mortgage buying spree, benefitting from the widespread and eventually vindicated belief that Washingtonwould back them up. 

Mr. Shiller limits the government’s role in property speculation to regulatory omission, but it was acts of policy commission that encouraged optimistic expectations in the market. He analyzes the irrational exuberance of markets while minimizing the adverse impact of government agents’ behavior.

This dichotomy in viewing market vs. government players is broadly shared and has had a major result. Those government agents receive ever more authority, with the Dodd-Frank Act giving the Fed and other bureaucracies wide open discretion in formulating rules. There is no evidence that they will behave any differently in the next cycle—-no reason they’ll change now that their failures have been rewarded.

In a WSJ video Mr. Shiller says fiscal stimulus and regulatory expansion are good but  confidence is weak and there is real risk of recession.  He suggests that the government lacks the ability to boost confidence. But policy makers did the wrong thing in the bubble. Likely they’re doing the wrong thing in the slump as well, destroying confidence through their interventions.

21 thoughts on “Policy Makers and Irrational Exuberance

  1. I will grant for the sake of argument Schiller’s psychological theories. What would have happened to all this exhuberance,however,if the Fed had merely adhered to the Taylor Rule? There would have been considerably less monetary fuel to sustain the housing boom.

    To speculate further, what if the world had been on a gold (commodity) standard? Then Fed officials would not have needed to divine when exhubernace had become irrational. There would have been an automatic break on the creation of dollar credits.

  2. Easy money seems to increase the propensity of “irrational exuberance” to take hold, amplifying the bubble. Then, afterwards, officials can point back and blame it all on irrational exuberance, when it was their easy money that got the ball rolling in the first place. Disentangling the two influences an empirical challenge, but there is one clear prediction from the Austrian story: the easy money came first.

  3. Jerry O’Driscoll–
    Re “I will grant for the sake of argument Shiller’s psychological theories.”
    Yes, I think it is useful to argue within the psychological framework he sets up. On his own terms, policy makers’ penchant to go along with market sentiment and push it further is yet another argument against the discretionary policies followed by the Fed.

    Of course, I’m not implying that this is the only issue.

  4. Lee Kelly–
    “Disentangling the two influences an empirical challenge, ..” I suspect there’s more research to be done on this.

    ” ..but there is one clear prediction from the Austrian story: the easy money came first.” Yes, though one could tell a more complicated story to fit the recent history of serial bubbles–a remarkable pattern, as a number of financial observers have remarked. Easy money leads to exuberance, which leads to a bubble, the wobbling of which causes the Fed to ease money again. A vicious cycle is set up that would result in serial bubbles.

  5. I concur with the argument that we illogically put more faith in government when there is turmoil even though it is just as fallible (with perhaps worse consequences) as any private institution. It seems such an obvious fallacy, but one that is unfortunately generally held.

    However, I don’t believe the portrayal of the Fed is 100% accurate, as I have argued in the past. For starters, in the late nineties, the Fed Funds rate was in the mid to high range of the Taylor rule “spectrum”, i.e. it was relatively tight by Taylor rule standards.

    As far as the housing boom, the Fed’s share of the Treasury market has been on a consistent downward trend since 2002-2003, dropping from a peak of 19.6% in 2002 to 15.9% at the end of 2007 (though the Fed’s absolute Treasury holdings did increase). So an argument would have to be made that the Fed was able to hold Treasury rates low while it gave up market share.

    In addition, adjusting for U.S. currency that went overseas, the U.S. monetary base increased at just 2% per year. By comparison, from 1975 – 1980, the monetary base increased at an annual rate of over 8.5%. There is, of course, an argument to be made that there should have been deflation compliments of a productivity norm. However, I believe it is a long stretch to claim the Fed was furiously printing money during the 2000’s.

  6. Well done, Chidem. Gerry’s point about the institutional context is important because it provides a way to endogenize putative swings in
    psychology states of market players. Shiller and others claim that “psychological exuberance” is independently causative to bubbles and market volatility. But that tends to take the easy road by claiming that expectations are exogenous with respect to the market process and the frameworks within which they operate. The importance of understanding how individuals are affected by uncertainty is not in dispute.

    The challenge is to embed individuals in a world where they learn and adapt. Claiming that market participants suddenly become “over/under-exuberant” might be true, but generalizing that to the level of an explanatory proposition in social theory strikes me as similar to claiming that unemployment during the 1930s was due to an outbreak of laziness among workers.

  7. J. Rietz,

    You make a good point re: how did the Fed manage interest rates in the 2000s? Friedman and Kuttner have a working paper showing that in the past several years the announcement affect has taken precedence over reserve management for the institution of monetary policy. See NBER working paper w16165.

  8. Justin Rietz–
    Re “in the late nineties, the Fed Funds rate was in the mid to high range of the Taylor rule “spectrum”, i.e. it was relatively tight by Taylor rule standards. ”
    The Fed changed course abruptly a couple of times during this period. The rate was high, then in 1998 there was a series of cuts in response to the events I mention in the post. The issue here is the impact of policy on the stock market boom. In ’98 the Fed showed it would step in to shore up the market–or so it seemed to market participants who expected this and were confirmed in that expectation. The result: the fast-expanding 1999 technology bubble.

    Once that became clear, the Fed changed course again and tightened.

  9. Chidem Kurdas –

    “In ’98 the Fed showed it would step in to shore up the market–or so it seemed to market participants who expected this and were confirmed in that expectation. The result: the fast-expanding 1999 technology bubble. ”

    In 1998, the fed funds rate was, according to the Taylor Rule, quite tight. For a good picture of Federal Reserve policy during the 1990’s in comparison to the Taylor rule, I suggest looking at an older issue of the Monetary Trends report put out by the Fed – here is a link to a 2003 issue: http://research.stlouisfed.org/publications/mt/20030201/mtpub.pdf. See page 10.

    While I am sympathetic to the Austrian Business Cycle theory, and am no fan of central banking, I also think we need to be careful how we parcel out blame. If the Fed wasn’t running loose monetary policy, even unintentionally, we need to look for other causes.

  10. Jason Rietz–
    You’re referring to the overall trend. I’m referring to the particular events in the Fall of 1998 that fueled the stock bubble of 1999.

    After banks agreed to take over and slowly liquidate the failing hedge fund, Long-Term Capital Management, the Fed started cutting rates– as the graph you link to shows. The Federal funds rate was subjected to three successive cuts, including an unusual one that took place outside the regular schedule of meetings by the Fed Board. The policy was meant to reassure people and it did — the market resumed its steep climb. Later the Fed reversed course.

    On the basis of this history, it is hard to avoid conclusion that the Fed blew air into the bubble.

  11. I should add that this 1998 episode is in addition to the 2000s easy money John Taylor analyzes in his book — link is in the original post. This example is a different sort of intervention but it vividly illustrates the Fed’s power in shaping expectations. I think the idea of a “Greenspan put”, that is the belief that the Fed provided insurance against market drops, was inspired by the ’98 experience.

  12. Chidem Kurdas –

    I agree that the LTCM bailout affected moral hazard. But if we accept the Taylor rule (which I don’t in all situations) the fact remains that the Fed didn’t run loose monetary policy in the mid to late 1990s. Yes, it did lower rates in response to ’98, but you still have to argue that lowering rates from tight to “medium” can affect the market. My position is that the market is too smart for that, i.e. it would see that rates were still relatively tight. (I might also argue that under a free banking system with private currency, banks may have well increased the monetary base in response to an international currency crisis.)

    Regarding the 2000’s and the Taylor rule, I believe that, during the 2003-2005 period on which he focuses, the real rate in the U.S. dropped due to the large inflow of foreign government capital into Treasuries (foreign governments being driven by currency policies rather than prices means we have a clearer picture of their impact). Foreign governments purchased 3x the amount of Treasuries vs. the Fed from 2000 – 2007, suggesting they had 3x the impact on real rates.

    On this same note, I don’t believe the Taylor rule (using Taylor’s recommendations for the variables’ values) accounts for changes in the real rate, so if the real rate did drop, his rule would recommend policy that is too tight.

    I do believe low rates helped fuel the housing bubble, but that foreign governments were to blame. Moreover, I think government regulations (FHA, CRA, Freddie / Fannie, interest rate tax deduction, etc.) were the main culprits.


  13. Justin–
    Re “My position is that the market is too smart for that, i.e. it would see that rates were still relatively tight.”

    It’s an interesting issue. My impression is that the market reacts to the direction of rate change, so the series of cuts in ’98 registered as monetary easing. However, that may be because Fed officials made the point that they were easing.

  14. I’d agree there is some market reaction purely based on the Fed’s direction of change. The open issue is how much.

  15. Justin-
    RE “government regulations (FHA, CRA, Freddie / Fannie, interest rate tax deduction, etc.) were the main culprits.”
    No doubt these all played a role and demonstrate government — or quasi-government — agents’ mental biases, as well as their pursuit of self-interest, of course. I did not mention in the post the public choice, self-interest aspect, in order to keep the argument within Shiller’s cognitive bias approach.

  16. I’m surprised no one has called Schiller on his main argument. Government — mainly local government here in the US — has played a huge role in artificially propping up real estate prices for decades. I’m talking about the scam known as urban planning.

    Urban planning agencies inevitably become quickly owned and operated by the people who own existing homes in each area, who then operate the planning system as a cartel, restricting new building as much as they possibly can in order to create or worsen an extreme, artificial shortage of housing, especially good housing. This shortage comes at the expense of people who need to move into that area to take jobs; people whose family has outgrown their living space; and especially, people who have unbuilt land and want to develop it or sell it to developers. But most of those people don’t already live and vote in the area of that planning agency, so they have no voice in it. Meanwhile the homeowners who control it not only gain undeserved increases in their property values, they get to keep using all that nearby unbuilt land as scenery without paying for it.

    The real estate markets will never behave rationally until this scam is abolished.

  17. It’s not like this hasn’t happened before. The Tulip Craze, the South Seas Bubble, the Mississippi Bubble, panics in 1819, 1837, 1857, 1873, 1892, 1907, and 1929; the recession of 1961; the computer glitch panic of Nov. 13, 1989.

    Making the basket really really big does not change the fact that all of your eggs are in it.

    The only people who got burned were the people who believed the government. … Well, except for the millions unemployed as a consequence of the frauds. Right now unemployment stands nearer to 50% than the 9% claimed by the Bureau of Numbers.

    We can all be as entrepreneurial as all get-out, but short of “fishes and loaves” we are stuck with a very poor economy in a debtor nation saddled with a tremendous moral hazard.

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