Chapter 10. Irrational Exuberance
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
Alan Greenspan, December 5, 1996
Baby boomers piled into mutual funds, inflating share prices and prompting fund managers to crowd into hot stocks. The 1997 Asia Crisis showed that they had become the world’s investors of last resort. It prompted China and other Asian countries to build up stockpiles of dollars. That lowered U.S. interest rates and allowed more bubbles to form.
When they have credibility, central bankers can move markets easily. Just asking one hypothetical question will do it. That is what happened on December 6, 1996, after Alan Greenspan asked the question that opens this chapter. It was buried deep in a long and often turgid speech, and he offered no answer, but the mere fact that he raised the question caused a fright. It implied that the level of asset prices itself worried him, and that he might raise rates to stop a bubble from forming. He rammed home his message by provocatively comparing the United States to Japan.
European stock markets fell by more than 4 percent within hours, the sharpest fall in several years.1 Greenspan proved deadly earnest. A few months later, with U.S. stocks back to setting new highs, Greenspan followed through, raised lending rates, and successfully engineered a 10 percent “correction” in U.S. stocks. But they did not stay down for long and soon surged upward once more. Greenspan had correctly diagnosed a deep-seated case of exuberance, but arguably, its roots were not irrational. By 1996, the post-war baby boomers were entering their 50s. Retirement was a fast-approaching reality and they needed to bolster their savings. Stocks had risen every year but one since Volcker brought inflation under control in 1982, so it was not surprising that boomers thought they were the best bet.
The ERISA reform of pensions in the 1970s had shifted the onus for deciding where to invest from paternalistic pension funds, which guarantee a proportion of their final salary as a pension, to individuals themselves. Institutions would have maintained a relatively conservative allocation to bonds. But individuals were given an ever broader choice of funds to invest in—ranging across the United States into international stocks. Many were making up for lost time after not saving much earlier, so they poured into the stock market. If there was a sell-off, all seemed to believe, the smart thing was to “buy on the dips.”
The Internet, an exciting new technology at the time, made playing the market much easier. Small investors could place money and switch it between funds with the click of a mouse. Generally, they put their money wherever the profits had just been. In the first nine months of 1997, immediately following the irrational exuberance speech, retail investors poured $177 billion into mutual funds. This helped complete the institutionalization of investment, with funds holding $2.4 trillion in stocks, a tenfold increase since the October 1987 Black Monday crash a decade earlier. Indeed, fund managers were increasingly alarmed by the money coming in their direction, which it was ever more difficult to invest sensibly.
Jack Bogle’s firm Vanguard was out-selling all others but was not happy about it. “We are very worried,” a spokesman said after record sales early in 1997. “We really are trying to put a damper on these numbers because we fear it is just going to add to the engines on this stock-market bandwagon, and more people are going to want to jump on. The last thing you want to do is throw yourself on to a speeding bandwagon.”2
Arthur Levitt, then the chief regulator of share trading as the head of the U.S. Securities and Exchange Commission, also sounded the alarm. “Investors are not as informed as they should be,” he said. “This is especially troubling because most of these new investors have experienced only a bull market. I fear that in a downturn those who don’t understand risk may react precipitously and carelessly, at great cost to themselves and our markets.” In other words, money that had hurried into the stock market could hurry out again at the first sign of trouble.
Irrational exuberance had its great test on October 27 that year. Its roots lay in a crisis on the other side of the world, for the “tiger” economies of South East Asia. After the Japanese bubble burst, Japan’s companies had started investing in their near neighbors. Western investors did the same. In the first half of the decade, share prices in Thailand, Malaysia and Indonesia, the developing fringe of the region, rose by between 300 and 500 percent.3
The region could not use the money. Its period of explosive growth almost over, its profits were stagnant. In South Korea, the region’s leader, half of the 30 biggest conglomerates made a loss in 1996.4 Instead of finding a productive home, the money pushed real estate prices into a bubble. Once those prices began to fall, the banks who financed them suffered crippling losses. When international investors sensed that Thai banks had a problem, flows of foreign capital went into reverse.
Underlying weaknesses were revealed once the region’s overvalued exchange rates came under attack, as investors pulled money out. With their currencies falling, the cost of repaying debts, mostly denominated in dollars, quickly became unbearable. In this situation, governments can only defend themselves if they have big reserves of foreign currency, which they can then sell to push up their own currency. Lacking such reserves, the governments of first Thailand, then Malaysia, Indonesia, and South Korea succumbed to devaluations—and faced up to repaying their piles of outstanding dollar-denominated debt.
Western markets nervously held firm as the Asian “contagion” spread across the Pacific Rim, but it could not last. On October 27, Hong Kong, the region’s biggest financial center, with a currency tied to the U.S. dollar, capitulated. Its stocks fell seven percent, provoking a day of reckoning in New York and London.
Selling started early, and intensified as the day drew on. Shortly after lunchtime in Wall Street, the Dow Jones Industrial Average had fallen 350 points, triggering for the first time the “circuit-breaker” rule the New York Stock Exchange had adopted in the wake of Black Monday ten years earlier. This mandated that trading should stop for 30 minutes. The idea was to get everyone to calm down. It had the opposite effect. Unnerved by the fact that trading had been halted, many traders pushed the button to “sell” as soon as trading restarted. Within minutes the Dow had fallen another 200 points, and the circuit-breakers forced the exchange to close almost an hour early, after the worst day for U.S. stocks in a decade. If the selling carried on the next day and turned into a rout, then a true global financial disaster seemed possible. How, Wall Streeters worried that evening, would the new army of retail investors react? Would they sell?
They need not have worried. Small investors were already buying. Overnight orders to buy stock placed with Charles Schwab, the biggest discount broker in the United States, outnumbered “sell” orders three to one—even as stock markets in Asia and Europe sold off in response to the events in New York. Once the day began, the volume of orders only intensified, with Schwab’s total volume running at three times its average. The same thing happened at all the big mutual funds.5
Panic on New York’s trading floors gave way to something like euphoria as traders realized the buying power from small investors was pushing prices up. They joined in. From its bottom that day, the Dow rebounded by almost 5 percent, one of the best days on record. Small investors had come to the rescue; the worst fears of Arthur Levitt had not come to pass.
Overconfidence, the vital ingredient of any bubble, ratcheted up another notch. Anxious to take the temperature of its customers, Schwab surveyed 500 of its callers on Tuesday. A full 92 percent of them claimed to have expected a market correction—which raised the question why they had not sold ahead of it—while 81 percent planned to buy “more stocks at lower prices.” With the market driven by investors who seemed certain that stocks, in the long run, were a one-way, upward bet, there was nowhere for stocks to go but up. Setting a sensible price for capital was impossible in such an environment.
The effect on institutions’ behavior was insidious. “Career risk” flooded out all other considerations. Logically, the sensible action at this time was to invest in “value” stocks (those that look cheap relative to the value of the assets on their balance sheets), rather than run with the herd. But if managers wanted to hold on to their careers, they had to do the opposite, and this served only to magnify the overconfidence of their clients. Value investors lost their jobs, while mainstream fund managers piled into popular stocks.
Exuberance also created “career risk” for politicians. The total assets of mutual funds, now greater even than the total assets of banks, were frighteningly transparent. If the stock market took a tumble, savers (who were also voters) would know straight away. Politicians already disliked raising interest rates because it makes it harder for people to borrow, but now they had a new incentive to avoid pushing down the stock market.
America’s baby boomers became the world’s investors of last resort. It was their money, ultimately, that drove up the tiger economies in the first place and then brought them down, and it was their willingness to feed more capital into markets that allowed the Asian currency crises to be contained.
In Asia, perceptions were different and politicians had incentives to behave in a way that also, in time, inflated global asset bubbles. After their crisis, they endured years of slow growth. Determined to be able to defend their currencies in the future, they bought dollars. Rather than pegging their currencies, which merely invited speculation, they let them float—but built huge stockpiles of dollar-denominated assets, usually in the form of bonds issued by the U.S. Treasury or by Fannie Mae and Freddie Mac, that could be sold in defense if their currencies should ever come under attack again. By buying U.S. bonds they pushed down their yields, and hence reduced interest rates for Americans. That stoked the final stages of the credit bubble.
International interconnections were now stronger and more fateful than ever. In the late 1990s, the aging baby boom generation had come together with a newly institutionalized investment industry to create a stock market that was almost incapable of going down.
In Summary
• Irrational exuberance made U.S. retail investors the world’s investor of last resort, pushing up prices across the world. That exuberance intimidated governments into trying to stop stock market falls and stoked moral hazard.
• It helped the world avoid a severe impact from the 1997 Asian crisis—but that crisis had the lasting legacy that Asian governments bought dollars and pushed down U.S. borrowing rates.