Irrational Exuberance

Article excerpt

How greed contributed to the making of an economic nightmare and our pathway to reform. BY PARVEZ AHMED

In December 1996, then-chairman of the Federal Reserve Board ("the Fed") Alan Greenspan said: "But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions ...?" Immediately after this pronouncement, Tokyo's stock market fell sharply and closed down 3%, Hong Kong's fell 3%, Frankfurt's and London's fell 4%, and America's fell 2 percent. This strong reaction made the term "irrational exuberance" famous and focused global attention on fear and greed as the two most powerful factors shaping market behavior. A decade later in May 2007, the Dow Jones Industrial Average, the most popular indicator of the stock market's health, after nearly doubling; dropped 49% in value, eighteen months later.

When financial markets gyrate Main Street feels the pain. Jobs are being lost at a record rate; unemployment, which stood at 4.5% in May 2007, reached 6.5% in Octo- ber 2008, a whopping 43% increase in about eighteen months. At the core of this malaise stands the housing market collapse brought on by the astronomical foreclosure rates. In August 2008, RealtyTrac ( reported 303,879 foreclosure filings: default notices, auction sale notices, and bank repossessions. This 27% increase from just a year ago revealed that one in every 416 American households had received a foreclosure filing during the month. These foreclosures led to a credit squeeze in the banking sector, which, in turn, led to the $700 billon bailout package passed by Congress that the then President Bush signed into law in September 2008.

Are Investors Really Rational? How did we get to this point? Why were ordinary taxpayers forced to underwrite the gam- bling practices of the rich and powerful (the $700 billion bailout)? It is indeed bad eco- nomics when the federal gov- ernment socializes risk while keeping profits privatized. But it would have been equally foolish to allow the federal government to stand on the sidelines while a terrible credit squeeze paralyzed the general economy. The bailout (euphemistically called the "rescue" package) will not solve the current economic problems that have surfaced due in part to decades of dogmatic belief that the "invisible hand" can keep markets efficient and in Pareto optimum.

Pareto optimality, named after Italian sociologist and economist Vilfredo Pareto (1848-1923), occurs when economic resources and output are allocated in such a way that no one can be made better offwithout sacrificing the well-being of at least one person. For over a decade, the regulators of the economy (the Fed and the Treasury) placed an inordinate emphasis on laissezfaire (hands-off or let do) ideology, thus favoring systems that tilted the playing field toward efficiency without regard for the equally important societal concern of fairness. Moreover, they assumed investors to be "rational," thus disregarding an emerging body of literature in finance and economics that posited investor behavior to be less than rational. This literature argued that investor behavior is influenced by such psychological biases as cognitive dissonance, which is the result of people pursuing heuristic simplifications (shortcuts to decision making) and selfdeception (people believing that they are better decision makers than they actually are).

Learning from History. Neglecting the past is a sure recipe for being condemned to repeat it. The 2008 crisis has many an- tecedents, perhaps none more important than the repeal of the Glass-Steagall Act in 1999, which allowed Wall Street and the banking system to become essential enablers of this crisis. Glass-Steagall was enacted in the wake of the 1929 crash, which many economists believe was partly responsible for the Great Depression that followed. While this legislation was a response to the country's greatest economic catastrophe (among other tell-tale signs, one in five banks had failed), its repeal came without much fanfare. …