After Irrational Exuberance, Irrational Pessimism

Investors now seem to be as deaf to good news about the economy as they were to warnings at the height of the stock bubble

By Laura D'Andrea Tyson

In December, 1996, Alan Greenspan warned that a wave of "irrational exuberance" was rolling through America's equity market. His warning fell on deaf ears. Enthralled by the promise of the Internet and a deregulated telecommunications market, wooed by media stories of rags-to-riches entrepreneurs, lulled by faith that the Federal Reserve could and would prevent a prolonged stock market collapse as it had in 1987, and cheered by a culture that extolled the pursuit of private wealth as public virtue, investors fed one of the largest speculative booms in economic history.

This boom, like its historical predecessors, created a climate of "infectious greed," as Greenspan recently put it. As in the past, the revelation of scandals nourished by avarice has been a major force behind the boom's gut-wrenching undoing. We may live in an era of new technology and new financial instruments, but the rise and fall of the U.S. stock market over the past six years confirms Harry S Truman's adage that the only thing new in the world is the history you don't know.

We have now entered the final phase of the boom-bust cycle--the search for villains for past ill deeds and the search for reforms to prevent future calamities. But in the panic to sell shares in U.S. companies, investors are deaf to good news about the resilience and productivity of the American economy just as they were deaf to bad news at the height of the market euphoria.

For the average American, with small holdings in the market, the greatest danger now is not the stock market's collapse. Rather, it's a sharp economic slowdown caused by a mood of irrational despair fed by press and political hype about what's rotten in American capitalism.

Beyond the despair, what are the appropriate policy lessons to be learned from the economy's most recent boom-bust binge? Truthfully, it is too early to know for sure, though that hasn't stopped Congress from passing a massive new corporate-responsibility law whose effects on financial markets and the costs of doing business will be uncertain for years to come. But a few policy lessons have already begun to emerge.

First, compensation packages that link executive rewards to the company's stock performance may work well when stock values accurately reflect underlying fundamentals such as efficiency and competitiveness. But such packages can distort incentives when stock values significantly deviate from fundamentals, as happens when irrational exuberance takes hold or earnings are manipulated by top management.

The great bull market of the 1990s wreaked havoc on the pay-for-stock-performance reward system, allowing corporate leaders to ride a bull market to huge windfalls of personal wealth and tempting some to artificially inflate earnings to keep stock prices rising.

To avoid these problems in the future, performance-based pay should be structured to reward executives on the basis of a company's performance relative to overall market or industry performance. And to reduce incentives for executives to manipulate earnings to boost share prices in the short run, companies should impose longer waiting periods between the date executives acquire stock--either through stock grants or through the exercise of stock options--and the time they are allowed to sell it. Finally, reining in grants of stocks and options would mitigate the yawning gap between executive and worker compensation, a gap that has aroused the public's resentment.

As for the accounting industry, the major lesson is that self-policing has failed. An independent accounting regulator is necessary to complement the work of the Securities & Exchange Commission. Both regulatory bodies must be granted the resources and respect they need to do their jobs. In recent years, under a Republican Congress dedicated to slashing discretionary spending and ridiculing government regulation, the SEC has enjoyed neither.

While the nation debates the reforms necessary to prevent another boom-bust cycle, the role of culture should not be overlooked. Greenspan argues that while humans have not become greedier, the avenues to express greed have grown enormously. Greed may indeed be a basic human emotion, but surely, humans can be encouraged to be more or less greedy by the values of the culture around them.

Without question, America's love affair with unfettered market capitalism and a culture that extols greed as public virtue, that sanctions huge inequalities in income and wealth as fair, that ridicules civic service, and that equates happiness with material success has encouraged more greed at the expense of other human emotions. Honesty, empathy, guilt, and a sense of fairness have all been sidelined. If our culture had placed more emphasis on such values, perhaps some of the excesses and swindles of the past few years might have been avoided. Maybe the pain that has resulted will trigger a healthy shift in our prevailing cultural norms.

Laura D'Andrea Tyson is dean of London Business School.

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