Dec. 8 (Bloomberg) -- Ten years ago this week, Alan Greenspan, then chairman of the Federal Reserve, slipped the phrase ``irrational exuberance'' into an otherwise unremarkable long speech on the role of central banks in democratic societies.

His use of the phrase triggered a debate about the role of asset prices in monetary policy decisions that has never ended.

In December 1996, the asset prices in question were those of equities. Many of Greenspan's critics later complained that after having raised the issue of a possible stock price bubble, he and his Fed colleagues didn't do enough to deflate it before its bursting led to the 2001 recession.

The same complaints about Greenspan -- who retired at the end of January after more than 18 years as Fed chairman -- and his refusal to deal with asset price bubbles also are being heard now regarding housing prices. In that sector, declining construction, plunging sales and falling prices are depressing U.S. economic growth.

In the case of housing, the specific criticism is that foolish worries about a possible episode of deflation -- a period of decline in the broad level of prices -- led Greenspan to lower the Fed's target for the overnight lending rate to only 1 percent in 2003. Super-low mortgage interest rates then sparked the housing boom, the critics argue.

However, even as he described how ``irrational exuberance'' could cause asset prices to climb rapidly, and perhaps add to inflationary pressures, Greenspan never suggested central banks should try to prevent a bubble from developing. Rather, if one did, he said, a central bank should only stand ready to limit the damage that might be done to the broader economy if the bubble burst.

What Irrationality?

In the December 1996 speech at a dinner in Washington at which Greenspan received an award from the American Enterprise Institute, the Fed chairman's use of the ``irrational exuberance'' phrase was so subtle that it was far from clear that he even had the U.S. stock market in mind.

``But where do we draw the line on what prices matter?'' he asked. ``Certainly prices of goods and services now being produced -- our basic measure of inflation -- matter. But what about futures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy?''

Sustained low inflation, of course, reduces risk and therefore ought to lead to higher asset prices, he said. ``But 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?'' he asked.

Not Worried

That was hardly a declaration that the Fed was so seriously worried about the level of stock prices that it was going to tighten monetary policy to prick whatever bubble may have been developing. When Greenspan spoke, the S&P 500 index stood at 744.38, up 21 percent over the previous year. It closed yesterday at 1,407.29, an 89 percent gain.

Furthermore, Greenspan's next words were: ``And how do we factor that assessment into monetary policy? We, as central bankers, need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy.''

I remember the speech and what followed vividly. A few hours before it was delivered, I read an embargoed copy and saw nothing in it that I thought merited a story in the Washington Post, for which I then worked. Perhaps if Greenspan hadn't also mentioned Japan in that key sentence, his subtly stated point might have escaped notice, as some of his other subtle points had.

Offering Hints

No matter, the Japanese press overnight jumped on the story, drawing the conclusion that the Fed chairman was hinting at rate increases to curb rising stock prices. The next morning a Post editor called me at home to ask if that interpretation was right and would I try to get someone at the Fed to confirm one way or the other.

I said I was sure the Japanese press was wrong, though I would check. I reached a top Fed staff member who had seen drafts of the speech, and he and two other senior staff members with him at the time all agreed: No, the chairman's comment had nothing to do with U.S. stock prices.

Later that morning I heard again from the staff member I had called. He said he had mentioned to Greenspan the assurance the trio had given me, and the chairman said, ``You had better call him back.''

Market Reaction

The stock market reacted the day following the speech, it declining only slightly, and then began again to forge new highs.

In congressional testimony the following February, Greenspan expanded on his ``irrational exuberance'' comments.

Analysts' projections of profit growth needed to justify the high level of stock prices would be validated only if productivity growth accelerated and increases in compensation did not, he said.

``Neither, of course, can be ruled out,'' Greenspan said in a context that made it clear he didn't really expect that to happen. Of course, it did.

Princeton University economics professor Burton G. Malkiel, author of the widely read book, ``A Random Walk Down Wall Street,'' said during a seminar at the university in April 2005, that when Greenspan caused a stir by mentioning ``irrational exuberance'' there was no bubble in stock prices.

And he and others at the seminar, including several present and former Fed officials, all agreed that the central bank should not try to target the prices of equities, homes or other assets.

That's the correct view, though the debate Greenspan sparked a decade ago has by no means ended.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: December 8, 2006 00:10 EST