The Hindu Business Line : Irrational responses to asset price changes

While some incremental tightening can check irrational exuberance, too much might push the economy into a recession. While it is good for the central bank to kill inflationary expectations, the action should not result in crushing entrepreneurship, which is vital for India's growth prospects. Inflation deserves to be controlled, but not by the use of measures that may create havoc in their wake.

Discussions about overheating in the economy and the correctness or otherwise of the RBI's response to recent asset price risks call to mind a famous statement by Alan Greenspan, the legendary former Chairman of the US Fed, about "irrational exuberance", made 10 years ago, in the backdrop of a soaring stock market and a strong US economy.

Mr Greenspan said in his cautionary observations: "How do we know when irrational exuberance has unduly escalated asset values? We should not underestimate the interactions of asset markets and the economy. Asset prices, particularly, must be an integral part of the development of monetary policy".

Recent statements of Dr Yaga V. Reddy, the RBI Governor, are similar in tone and substance. He must have drawn inspiration from an eminent role model when he decided to invoke the asset price growth in his stand on overheating. It is, therefore, appropriate to see how exactly history has judged Greenspan's statement about irrational exuberance.

For this, I draw on Prof Jeremy J. Siegel's (Professor at Wharton School and noted authority on stock market) contribution on the subject in Wall Street Journal of December 7, 2006, entitled "Irrational Exuberance Reconsidered". He concedes that stocks were, indeed, surging when Greenspan spoke at the annual dinner of the American Enterprise Institute.

The Dow Jones industrial average had crossed 5000 in November 1995 and 6000 in October 1996. On the day Greenspan spoke, the index had risen to 6431, twice the level it reached only four years earlier.

Many critics had argued that the market was too high and the Fed ought to step in and "cool" the market, lest a subsequent crash cripple the economy. Mr Greenspan's speech did what it was intended to. It cooled the market and sent shock waves around the world's financial markets. Stock markets around the world slumped. The Dow investments fell over 100 points when the market opened the next morning. But, as time went on, the markets recovered and so did the Dow.

Irrational exuberance

Mr Greenspan did little further to back his cautionary statement. In fact, he noted the surprisingly strong growth in productivity and corporate profits, which may have justified higher stock prices.

Warning about bubble

But economists critical of Greenspan, noted that if he had taken strong action, he could have averted the subsequent collapse in 2001 and 2002. The critics argued that if he had stuck to his guns, he could have avoided the bubble in the stock market.

Mr Siegel quotes The Economist of London as saying: "If the Fed had popped America's bubble sooner, the economy would be healthier. Ironically, Mr Greenspan was the first to warn of a bubble in 1996, when he drew attention to the market's irrational exuberance. What a pity he failed to put his monetary policy where his mouth briefly was".

Mr Siegel remarks that in the after-light of experience, we can judge whether the market was irrationally exuberant in 1996. The answer, he says, is decidedly a `No'. Had the market been irrationally overvalued, it would have shown poor returns in the coming decade. But it did not.

He points out how, during the decade since Greenspan's speech, the rate of returns for the broadest index of US stocks was 8.2 per cent per year. International stocks have shown even higher returns. This is in spite of the recession that intervened. Even taking inflation into account, the real returns from American stocks were very close to those revealed by long-term equity studies. There is no evidence that the markets were over-valued at the time Greenspan said they were.

There was, indeed, a bubble in the American stock market, but it was confined to the technology sector. Technology stocks soared in 1999 in the wake of the Internet fad and the surge in IT spending following the Y2K scare. This bubble had nothing to do with "irrational exuberance". The question that should be asked is whether the Fed should have acted against the tech bubble.

Rate increases

The fact is that Mr Greenspan's Fed did act to curb the tech boom. It raised interest rates six times from the summer of 1999 to March 2000 until the Fed funds rate reached 6 per cent, the highest level in nine years. But Mr Siegel notes that investors in tech stocks laughed at these rate increases. Tech stocks would be little influenced by rising interest rates as these firms had little debt and tech spending was too important that it was not restrained by higher short-term interest rates.

The conclusion that Prof Siegel draws is that Mr Greenspan raised a caution against irrational exuberance of stock markets when it was unjustified and that he raised interest rates to control a tech boom when they did not work.

Mr Greenspan himself seems to have shared this scepticism of both his action and inaction. Speaking at the annual Kansas City Fed Economists' Conference in Jackson Hole in August 2002, he said: "Historical data suggest that nothing short of a sharp increase in short-term rate 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 1990s bubble is most surely an illusion". This is a strong learning from Greenspan's experience.

Mr Siegel goes on to comment that if Mr Greenspan had tightened further in 1999, the non-tech firms — the brick-and-mortar firms — would have been pushed further into recession.

There is a lesson that our own central bankers have to learn from the experience of Mr Greenspan. Tightening can do little to stop bubbles. Too much tightening might push the economy into a recession.

The Japan experience

Similar but disastrous episodes of untimely tightening in terms of overkill abound. One that comes to mind is that of Governor Mieno of Japan in the early 1990s when in order to choke off a real estate bubble, he tightened money supply in Japan a bit too drastically. He succeeded, but consequently pushed Japan into a decade-long recession and Japan is still paying the price of Mieno's ill-timed decision.

I do hope that Mint Street will not fight shy of learning from Mieno and Corregan. It needs to do a reappraisal of whether the exuberance of markets has been irrational or fully borne out by increase in industrial and other productivity and robust GDP growth.

It is wise to learn in the school of other central bankers' experience rather than pay the price for our own mistakes.

It is, of course, good to kill inflationary expectations but the action should not result in crushing the prospects of growth and entrepreneurship, the essential revival of animal spirits that characterises India's economy and its business class that are vital to its growth prospects.

While the debate on overheating is on between North Block and Mint Street, it is good to remind ourselves that we should not be prisoners of central banking dogma. Greenspan himself recognised that overheating in the sense of asset price inflation should be handled in a spirit of humbleness. Central bankers are powerful but not omniscient. They should use their strength with the humility that comes out of learning from experience.

Inflation deserves to be controlled, but not on the basis of measures that may create havoc in their wake.

Irrational exuberance about market fluctuations is an occupational hazard which central bankers need to control as much as inflationary expectations based on retrospective data.