How Irrational Is Our Exuberance?

Fortune issue: April 17, 2000

First Principles

How Irrational Is Our Exuberance?

By N. Gregory Mankiw

Alan Greenspan is not known for his pithy prose, but he coined the financial phrase of the decade: "irrational exuberance." The Fed chairman uttered these infamous words in a speech on Dec. 5, 1996, when the Dow was at 6437. Irrational Exuberance (Princeton University Press) is also the title of the new book by Yale economist Robert Shiller. Shiller is no newcomer to the bubble theory of the stock market. He briefed Greenspan two days before that 1996 speech, and he holds the view with greater conviction than Greenspan ever did.

Despite (or perhaps because of) the 4000 Dow points the market has added since the Shiller-Greenspan team first pronounced it overvalued, Shiller is not backing down. He tells us, "The high recent valuations in the U.S. stock market come about for no good reasons . . . . The market is high because of the combined effect of indifferent thinking by millions of people, very few of whom feel the need to perform careful research on the long-term investment value of the aggregate stock market, and who are motivated substantially by their own emotions, random attentions, and perceptions of conventional wisdom." Put simply: If you haven't gotten out already, do it now.

Of course, there is a long tradition of skepticism about the stock market's rationality. The great British economist John Maynard Keynes wrote that investors were driven by their own "animal spirits," which were major sources of the business cycle. Treasury Secretary Lawrence Summers, during his previous academic career, suggested that markets were dominated by the "noise traders" and proposed that such speculation be tamed by a tax on transactions. All this was before the rise of online day trading.

Irrational Exuberance is the latest contribution of the bubble theorists. One strength of the book is that it provides easy entry into "behavioral finance"--a small but growing field of finance experts who take seriously the lessons of psychology.

Shiller evaluates the evidence casting doubt on man's ability to process information. In one experiment, subjects were asked to estimate the percentage of African countries in the United Nations. But before they answered, a roulette wheel was spun, and they were asked whether the number was larger or smaller than the number that came up on the wheel. The result? The larger the outcome on the wheel, the more countries people thought were in the U.N.--even though the wheel's outcome was extraneous.

Going from a strange psychology experiment to the current level of Nasdaq is no small leap. But what psychologists are telling us is that people are not as rational as economic theorists like to assume. If people are not smart enough to separate a spin on a roulette wheel from the percentage of African countries in the U.N., how can they hope to calculate the value of the market? Perhaps we all look at the rapid growth of the Internet and mistakenly conclude that it will mean rapid growth in corporate earnings.

Surprisingly, Shiller's book never tells us what the right level of the market really is. How far does the Dow need to fall before Shiller calls an end to the bubble? His favorite valuation measure seems to be price divided by an average of the past ten years' earnings--an oddly backward-looking variable for a market that is supposed to be forward-looking. By this measure, the market could fall by half and still look expensive.

Shiller gives little credence to the view that we are entering a new era of rapid growth. He makes a good case that such claims are common whenever the market valuations hit extreme levels, such as in 1901, 1929, and 1966. But is the market never right? The stock market collapse in 1973-74 did signal a new era--a new bad era of slow productivity growth that lasted more than two decades. Couldn't a stock market boom ever be a signal of good things to come?

Not every piece of evidence in the book points to excessive optimism. Shiller's survey of high-income investors found that people expect the Dow to rise about 4.6% in the next year. He discredits the widely cited Paine Webber/Gallup poll in which expectations are much more optimistic. That survey made people choose from a range of answers, none of which included a market decline. But Shiller's respondents aren't prompted, and about a third of them expect stock prices to be lower a year from now. This is hardly irrational exuberance.

In the end, Shiller might be right that the U.S. bull market of the 1990s will prove as ephemeral as the Japanese bull market of the 1980s. His book is a useful antidote to the many Pollyanna books out there, such as Dow 36,000. But Shiller might also be wrong. Given how little economists know about the stock market, his firm conviction that we're in for a decade or two of poor performance left me wondering whether Shiller was suffering from irrational malaise.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.