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Irrational Exuberance?

May 5, 2000

Tags Booms and BustsFinancial MarketsU.S. EconomyBusiness Cycles

     In his book Irrational Exuberance, Robert Shiller, a professor of economics at Yale, attributes the observed stock market mania to investor’s psychology. Shiller believes that stock market players are driven by impulse and herd behavior. The attempt to explain the present stock market behavior by means of these factors presents investors as automatons who react mechanically.

     This view is completely misguided. Investor’s actions, like that of all market actors, are conscious and purposeful. It is not some mysterious impulse or herd behaviour that causes investors to generate massive rises in prices that are out of touch with equilibrium, or fundamentals, but rather investors' conscious actions.

    In a free, unhampered market economy, entrepreneurial errors generate incentives for their corrections. All other things being equal, let us assume that too much capital was invested in the production of product A, and that too little capital was invested in the production of product B. The effect of the over-investment in the production of A is to depress its profits, because the excessive quantity of A can only be sold at a price that are low in relation to costs.

    The effect of under-investment in the production of B, on the other hand, will lift its price in relation to costs, and thus will raise its profit. Obviously, this will lead to withdrawing of capital from A and a channelling of it toward B, implying that if investment goes too far in one direction, and not far enough in another direction, this will set in motion counteracting forces of correction.

    For large deviation of stock prices from their fundamentals to occur, there must be a mechanism that undermines the functioning of the market economy. According to Ludwig von Mises, this mechanism is set in motion by the central bank’s monetary policies. Trouble erupts whenever central bank officials try to improve on the working of the free market economy.

    While in a free, unhampered market errors generate incentives for their corrections. These incentives are removed once the central bank begins to inject money, thereby artificially lowering interest rates below the level dictated by consumer time preferences i.e. demand and supply of savings). In a free unhampered market economy, interest rates in financial markets will mirror consumers' time preferences. By responding to interest rates, entrepreneurs are, in fact, abiding by consumers’ instructions. Once interest rates in financial markets are lowered artificially, they cease however, to reflect consumers' time preferences. This, in turn, means that entrepreneurs, once they are reacting to interest rates in financial markets, are committing errors, i.e., doing things against consumers' wishes.

    As long as the artificially low interest-rate policy remains in force, there are no ways or means for entrepreneurs to know that they are committing errors. On the contrary, as the policy of the monetary pumping and hence artificial lowering of interest rates intensifies, it generates apparent profits and a sense of prosperity. The longer the period of artificial lowering of interest rates is, the more widespread will be the errors, i.e., the disobedience of entrepreneurs regarding the will of consumers.

    The discovery that entrepreneurs didn't abide by consumers’ instructions occurs once the central bank tightens its monetary stance. On this Mises wrote, "As soon as the credit expansion comes to an end, these faults become manifest. The attitudes of the consumers force the businessmen to adjust their activities anew to the best possible want-satisfaction. It is this process of liquidation of the faults committed in the boom and readjustment to the wishes of the consumers which is called depression."

    The Misesian theory shows that the artificial lowering of interest rates sets in motion expectations for strong activity and good profits in the capital goods sector (information technology falls into this category). This, in turn, raises the allocation of funding towards the capital-goods sector in relation to the consumer-goods sector. This lifts stock prices of capital goods producing companies relative to stock prices of consumer goods producing companies.

    If the lowering of interest rates is a one-time-only event, and is not supported further by the central bank, then the market interest rate will rise. In response to this, stock prices of capital goods-producing companies will weaken, while those of consumer-goods-producing companies will strengthen on a relative basis. If, however, the central bank clings to its loose monetary stance, this will reinforce the rise in stock prices of capital-goods-producing companies relative to the stock prices of consumer-goods-producing companies.

    Relentless monetary pumping by the central bank that is further amplified through fractional reserve banks raises all prices in money terms, including prices of stocks. Whenever the central bank reverses its monetary stance, a stock market bust is set in motion. The severity of the bust is dictated by the magnitude of the preceding boom, i.e., the preceding bull market and by the state of the real pool of funding.

    Thus, the longer the bull market, the more widespread the errors will be, and therefore the more severe the bust (i.e., the bear market) will be. If the real pool of funding is expanding, the severity of the bust will be cushioned. If, however, the pool is shrinking, then the bear market could be more protracted and severe. In this way, the Austrian or Misesian theory provides the rationale behind prolonged deviation of stock prices from their fundamentals.

    In the US the severity of the misallocation of resources and hence entrepreneurial errors is depicted by the loose monetary stance of the central bank. In January 1980 the US Federal Reserve Board money base stood at $132 billion. By the end of April the base was $574.2 billion, an increase of 335%. Furthermore in April 1980 the federal funds rate stood at 17.6%. By December 1993, in response to massive monetary pumping, the rate collapsed to below 3%.

    We can thus conclude that, contrary to Shiller, thee present sharp deviation of stock prices from their fundamentals is the result of loose monetary policies of the US central bank, not a failure of human psychology.

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Frank Shostak is chief economist at Ord Minnett, Australia. Send him MAIL.

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