Policy Makers and Irrational Exuberance

Robert Shiller says the speculative bubble in real estate was driven by “a contagion of optimism” that pushed up prices and expectations in a feed-back loop. This epidemic apparently engulfed regulators as well.  “Government policy makers breathed in the same optimism, which no doubt encouraged them to be lax on regulatory restraint,” he writes in a NYT column.

This is a plausible explanation of the psychological mechanism that operates in any bubble. It eventually collapsed and led to the property slump that underpins the current economic malaise And Professor Shiller is right that public officials are not immune. But federal entities breathing in heady fumes is different from anybody else breathing in the same.

After all, the federal government is uniquely big and powerful. Mr. Shiller ignores the institutional implications of this. The key question is,  Why should it be any different the next time around?

Consider that the property bubble followed the 1990s stock bubble. In December 1996, then Federal Reserve Chairman Alan Greenspan asked, “But how do we know when irrational exuberance has unduly escalated asset values?” Once that bubble burst, he argued that there is no way of knowing until it’s over.

But in 1998 the Fed further stoked the red-hot stock market by repeatedly adding to the money pipeline. This was in response to what looked like a crisis caused by Asian debt problems, a temporary default byRussia and the near-failure of hedge fund Long-Term Capital Management. In the early 2000s it did so again in response to the downturn.

Surely the Federal Reserve’s interventions threw the economy off track, as John Taylor has argued. Optimism was fueled by the belief that the Fed would intervene to protect asset prices, an idea that came to be known as the Greenspan put. Meanwhile, Fannie and Freddie continued their mortgage buying spree, benefitting from the widespread and eventually vindicated belief that Washingtonwould back them up.

Mr. Shiller limits the government’s role in property speculation to regulatory omission, but it was acts of policy commission that encouraged optimistic expectations in the market. He analyzes the irrational exuberance of markets while minimizing the adverse impact of government agents’ behavior.

This dichotomy in viewing market vs. government players is broadly shared and has had a major result. Those government agents receive ever more authority, with the Dodd-Frank Act giving the Fed and other bureaucracies wide open discretion in formulating rules. There is no evidence that they will behave any differently in the next cycle—-no reason they’ll change now that their failures have been rewarded.

In a WSJ video Mr. Shiller says fiscal stimulus and regulatory expansion are good but  confidence is weak and there is real risk of recession.  He suggests that the government lacks the ability to boost confidence. But policy makers did the wrong thing in the bubble. Likely they’re doing the wrong thing in the slump as well, destroying confidence through their interventions.

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