Commentary: Is "Irrational" Exuberance Perfectly Rational?

The notion of a financial "bubble" calls up apocalyptic visions of a market in which people's hopes outrun their common sense. The resulting mass euphoria and speculative frenzy abruptly ends with catastrophic collapse and widespread economic hardship.

Today, a growing number of economists and financial analysts worry that the market is in the grips of such a mania. In his recent book Irrational Exuberance, Yale University economist Robert Shiller writes that "the present stock market displays the classic features of a `speculative bubble': a situation in which temporarily high prices are sustained largely by investors' enthusiasm rather than by consistent estimation of real value." The implication: U.S. prosperity is hostage to the whims of investor mood swings.

Nevertheless, the cautionary lessons typically drawn from past manias and bubbles may be deeply flawed. It was largely economic fundamentals and not investor irrationality that drove price gyrations during some of history's grandest speculative episodes, argues Peter M. Garber, global strategist at Deutsche Bank and economist at Brown University. And today, it will be real economic events such as the eventual success or failure of Internet-related companies--rather than manic shifts in investor psychology--that will determine what happens to the market.

MISCONCEPTIONS. In his forthcoming book Famous First Bubbles, Garber examines three of the biggest and well-known bubbles of the past: Tulipmania in Holland, the Mississippi Bubble in France, and the South Sea Bubble in England. In all three cases, he shows that rather than being driven solely by investor psychology, there were good economic reasons why asset prices soared and then fell.

Take Tulipmania. The Dutch rush to invest in rare tulip bulbs in the mid-1630s is repeatedly cited as the prototypical bubble. According to the usual story, an irrational Dutch mania for tulips sent rare bulb prices soaring into the stratosphere, culminating in a spectacular one-month surge in prices. The frenzy suddenly ended in February 1637, and prices tumbled sharply as speculators panicked. "The collapse of tulip prices had a chilling effect on Dutch economic life in the years that followed--there ensued, in modern terminology, an appreciable depression," writes economist John Kenneth Galbraith in A Short History of Financial Euphoria.

But Garber shows that Tulipmania is better understood as a normal working of supply and demand. Holland dominated the new market for tulips, and the high prices were for particularly beautiful and rare varieties not easily duplicated. And with the exception of the final price spike, much of the demand was driven by French fashion. Moreover, rather than wiping out Holland's economy, historians agree that the price swings had almost no economic impact.

What about the Mississippi and South Sea Bubbles, both in the early part of the 18th century? The conventional story makes out both of these to be classic examples of investor overexuberance. In each case, aggressive financiers offered to refinance war debt held by essentially bankrupt nations in exchange for potentially lucrative monopolies on foreign trade. Selling successive waves of stock to an eager public, the companies expanded far too rapidly, eventually collapsing as investors realized the promised wealth would never materialize.

REASONABLE RISK. But that's far from saying investors took leave of their senses. Both these enterprises had a chance of high payoffs, especially in France where the leading company of the Mississippi Bubble, Compagnie des Indes, had a monopoly on all French trade outside Europe. And while the financial schemes underlying the bubble clearly got out of control, they were based on a sound intuition about what sort of monetary reforms were needed. Issuing notes to fund government debt, as these companies did, was a crucial step toward creating true central banks and a financial system that could fund large-scale industrial growth.

Similarly, today's talk about irrational exuberance largely misses the point. Sure, many high-tech companies will go under, some spectacularly. And it might well be that the Internet does not pay off as big as investors expect, in which case the market will go down. Or the Net may far exceed expectations. Either way, the willingness to take risks is what is propelling the U.S. in its longest expansion in history. And that's no bubble.

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