Irrational Exuberance - Explained
What is Irrational Exuberance?
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Table of ContentsWhat is Irrational Exuberance?How Does Irrational Exuberance Work?
What is Irrational Exuberance?
Irrational exuberance is a term used when the enthusiastic nature of investors towards a certain asset or financial instrument drives the price or the value of such asset or instrument to a point that defies fundamentals. Fundamentals in this case refers to news and information about a company or an asset. When the performance of an asset of financial instrument is taken into question when valuing them, then it is said to be fundamental analysis. However, when irrational exuberance comes in, fundamentals are put to rest and sentimental becomes the order of the day. The term irrational exuberance is coined from a 1996 speech delivered by Alan Greenspan titled The Challenge of Central Banking in a Democratic Society. The speech was delivered at a point where irrational exuberance was at its peak; it was during the dotcom bubble. Greenspan asked the following question in his speech: But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolong contractions as they have in Japan over the past decade? An how do we factor that assessment into monetary policy?
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How Does Irrational Exuberance Work?
Irrational exuberance is said to be a financial problem as it creates a bubble in asset prices. In financial terms, a bubble refers to a false increase in the price of an asset, which would later decline substantially to the point that the price will become lower than what it was initially valued at even before the start of the bubble. In a case of irrational exuberance, when the bubble bursts, investors engage in panic selling, and sometimes they tend to sell their assets for way less than they're really worth. In some cases, the panic can plunge the economy into a recession, as there is a possibility of it spreading to other asset prices. According to Greenspan, central banks should raise interests in areas where they feel that a speculative bubble is building. He also asked about the possibility of central banks addressing irrational exuberance via monetary policies. Economist Robert Shiller also created a book in 2000 and named it Irrational Exuberance. His book painted a bigger picture of the stock market boom that lasted from 1982 to the period of the dotcom years. Shiller's book presents 12 factors and drivers behind the stock market boom and recommended changes in policy for better management of irrational exuberance. In 2005, Shiller released another edition of the same book the second edition and this time, he was warning about the housing bubble burst.