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Irrational Exuberance

Speculative Volatility In A Free Society

The market is high because of the combined effect of indifferent thinking by millions of people who are moved significantly by their own emotions, random attentions and perceptions of conventional wisdom. The news media offers them quantitative analyses that give them an incorrect impression about the aggregate stock market level. The tendency of speculative bubbles to grow and then contract can make for an extremely uneven distribution of wealth. Although the market appears to have substantial long-term forecast ability when it is very overpriced or alternatively, when it is under-priced, there is always considerable uncertainty about its outlook.



If the precipitating factors continue to support the market at its recent record level, and do not increase the market's value anymore, then returns in the stock market will be confined to dividends. The precipitating factors are most likely to grow in the 21st  century and cause substantial increases in the stock prices. Participation in the Internet gives people a personal sense of technological progress which in turn may give them an exaggerated sense of the promise of technology.


With the expansion of online trading of stocks, creation of new electronic stock, derivative exchanges, and the implementation of twenty-four hours trading, there has been an enormous growth of opportunities to trade stocks.


The focal point of news may shift away from investments soon. There is a fundamental uncertainty whether the extremely low rates of inflation that were seen recently would continue. Low inflation would continue to promote low nominal yields on fixed-income investments and thus encourage high valuation on stocks. The rise of gambling activities seems unlikely to be reversed. The strong perception that the Baby Boom supports the stock market will eventually fade. All of the changes suggest a poor long-run outlook for the stock market.



New precipitating factors, supportive and destructive of market value will undoubtedly develop. Some of the factors that could interrupt earnings growth are - decline in consumer demand, heightened foreign competition, an oil crisis, decline in employee morale and productivity, failure of major technological initiatives, etc. A number of these problems could occur together as it tends to precipitate others through its effect on society and the economy.



Many of the potential causes of earnings reversal have to do with changes in morale, loyalty and sense of fairness among the investors. It was such resentment of business that ended the "community of interest boom" in 1901 and encouraged the growth of socialist and communist movements. The Internet is the symbol for much that is new and exciting in technology today and it is the US software companies that seem to dominate it. If a moral basis for resentment gains solid ground in public thinking, it could lead to heightened efforts to compete with or totally exclude American corporations.



The concern about the adverse effects of atmosphere polluting emissions drove the 1997 Kyoto Protocol to instruct various countries to cut down on their emissions of carbon dioxide and other greenhouse gases. But instead, the level of emissions has been increasing rapidly, mostly in the developing countries.



A substantial fall in the market would leave some people extremely poor while leaving others considerably rich. Some people who rode the market up to new prosperity will have lightened up on their stock holdings and would walk away with profits, whereas others who had recently entered the market would only take losses. The effects on the lives of people who had become too dependent on stocks as investments, is unimaginable. The first step for investors should be to reduce holdings of stocks. One should not be overly dependent on any one investment itself. Investors should also increase their savings rate.



401(k) and similar plans are designed to give ordinary people economic security in retirement. The shift toward defined contribution pension plans has been good as it is indexed to inflation. Properly designed defined benefit plans offer risk-reducing advantages, which are important for lower-income pensioners. Government bonds would be a much safer option than the stock market. And yet, there is little encouragement on the part of employers or the government to make people shift their retirement funds into bonds. The current policy of providing choices to participants by employers, without any strongly worded advice to diversify invites serious errors. In the future, as a greater number of risk management contracts become available, employees should be advised to take advantage of them.



Having marvelled at the high returns in the markets, Americans are wondering why they have earned so much lower a return on their contribution to social security. The old family system of taking care of your aging parents out of feelings of love, gave rise to effective intergenerational risk sharing. The problem with the family acting as an economic risk sharing institution is that it is unreliable. In the US, social security is primarily a pay-as-you-go system. Inflation investment bonds are not investments for society as a whole since their net value is zero. The first generation's "windfall gain" was probably offset by reduced levels of care from their children. Reforms of social security should take the form not of investing the fund in the stock market but of making the system more responsive to economic risks.



There have been cases where tightened monetary policy was connected to the bursting of stock market bubbles. For example, in 1929, the Federal Reserve raised the rediscount rate from 5% to 6%, for the purpose of checking speculation. The Fed continued the tight monetary policy and saw a deep stock market decline and a recession into the most serious depression ever. Interest rate policies affect the entire economy in fundamental ways. For instance, authorities should not normally try to burst a bubble through aggressive tightening of the monetary policy.



A popular way of restraining speculation in financial markets is for intellectual leaders to call the attention of the public to over and under-pricing errors as and when they occur. In each of the three major market peaks, that is - peaks of the late 1920s, mid-1960s and mid-1990s, the Head of The Federal Reserve System issued warnings that the stock market was overpriced. A warning against stock market excesses by a Federal Reserve Chairman was not made again until Alan Greenspan's "irrational exuberance" speech in December 1996. The pronouncements of opinion leaders and moral leaders can have a stabilizing effect on the market.



Another method used for reducing market volatility has been to shut down the market in times of rapid price changes. For instance, the "circuit breakers" mechanism adopted by the stock exchanges. It is not clear whether these relatively short closings do very much to restrain one-day price-changes. These long-term price movements take place over years and represent really big stock price shifts. Other suggestions include slowing the pace of trading to discourage frequent trade. James Tobin proposed that the speculative price movement in the market for foreign currencies be restrained by levying a transaction tax on them. Institutional investors have bubble expectations, in essence, expecting an increase and then a decrease in stock prices. Real estate market seems to be extremely vulnerable to speculative bubbles and crashes.



In order to ensure longer-run economic stability, the best stabilizing influence on markets can be to broaden them to allow many people to trade as frequently as possible. Speculative bubbles are heavily influenced by word-of-mouth effects, foreign investors are less likely to go along with a bubble, and they may even trade in a way that would tend to offset it. Sudden price changes are not as bad, (in terms of their impact on the welfare of the economy), as the development of a speculative bubble that results in a worse crash in the future. Brennan proposes to shift public attention to fundamentals rather than to longer-run holdings. New institutions or markets should be created to make it easier for individuals to get out of their exposure to the stock market. This will allow trading of major risks that are untradable today. Retail institutions such as home equity insurance or pension plan options that correlate negatively with labour income or home values will help people make use of risk management tools. Creation of new markets may have the benefits of creating new risk management opportunities and might broaden the scope of market participation. The diversity of investment opportunities and the attention focused on fundamental risks by the macro markets ought to stabilize our economies and our lives.



In order to encourage proper risk management, authorities should stress more upon genuine diversification. People must invest outside the US stock market or US equity mutual fund to achieve true diversification. They must pay attention to other existing risks. Since labour income and home equity account for the bulk of most people's wealth, offsetting the risk to these is the critical function of risk management. Making such risk-offsetting investments is called 'hedging'.



The problems posed for policy markets by the tendency for speculative markets to show occasional bubbles are deep ones. Speculative markets perform critical resource-allocation functions, and any attempt to tame these bubbles interferes with these functions as well. We cannot shield the society from the effects of waves of irrational exuberance or irrational pessimism entirely. The most important thing to remember while experiencing a speculative bubble in the stock market is to not let it distract us from important tasks such as the encouragement of increased participation of people in more and freer markets, and designing better forms of social insurance and creating better financial institutions.

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