along with the manufacturing sector and the rest of the economy.
No one could convincingly explain why the statistics were off, I said.*
But I was reasonably confident that the risk of inflation was too weak to warrant
a rate hike. My recommendation was that we simply watch and wait.
This argument didn't convince everyone—indeed, we are still debating
the nature and extent of information technology's impact on productivity.
But it cast enough reasonable doubt that the committee voted 11 to 1 to
keep the rate where it was, at 5.25 percent.
*Some argued that service purchases by goods manufacturers were being mispriced in the calculations
and that the growth of total output per hour was correct, but goods production and
output per hour were being overestimated at the expense of service output and productivity
growth. While technically possible, this explanation seemed very unlikely.
173
THE AGE OF TURBULENCE
We did not find it necessary to raise rates for another six months—and
then only to 5.5 percent, and for a different reason. GDP continued to
grow at a solid pace, unemployment shrank, and inflation stayed in check,
for another four years. By not being too quick to raise rates, we helped clear
the way for the postwar period's longest economic boom. This was a classic
example of why you can't just decide monetary policy based on an econometric
model. As Joseph Schumpeter might have pointed out, models are
subject to creative destruction too.
E
E
ven rising productivity could not explain the looniness of stock prices.
On October 14, 1996, the Dow Jones Industrial Average vaulted past
6,000—a milestone achieved, declared a front-page story in USA Today,
"on the opening day of the seventh year of the most consistent bull market
in history." Papers all across the country put the news on the front page too.
The New York Times noted that more and more Americans were shifting
their retirement savings into stocks, reflecting "a widespread belief that the
stock market is the only place to make long-term investments."
America was turning into a shareholders' nation. If you compared the
total value of stock holdings with the size of the economy, the market's significance
was increasing at a rapid rate: at $9.5 trillion, it now was 120 percent as
large as GDP. That was up from 60 percent in 1990, a ratio topped only by
Japan at the height of its 1980s bubble.
I had ongoing conversations with Bob Rubin on the subject. We were
both somewhat concerned. We'd now seen the Dow break through three
"millennium marks"—4,000, 5,000, and 6,000—in just over a year and a
half. Though economic growth was strong, we worried that investors were
getting carried away. Stock prices were beginning to embody expectations
so exorbitant that they could never be met.
A stock-market boom, of course, is an economic plus—it predisposes
businesses to expand, makes consumers feel flush, and helps the economy to
grow. Even a crash is not automatically bad—the crash of 1987, hair-raising
though we'd felt it to be, had very few lingering negative effects. Only when
a collapsing market might threaten to hamstring the real economy is there
174
IRRATIONAL EXUBERANCE
cause for people like the treasury secretary and the chairman of the Fed to
worry.
We'd seen that sort of disaster happen in Japan, where the economy
was still crippled from a stock and real estate collapse in 1990. While neither
Bob nor I thought the United States had yet reached the bubble stage,
we couldn't help but notice that more and more households and businesses
were exposing themselves to equity risks. So over breakfast we often discussed
what we should do in the event of a bubble.
Bob thought that a federal financial official should never talk about the
stock market in public. An inveterate maker of lists, he offered three reasons
noted subsequently in his memoirs. "First, there's no way to know for
certain when a market is overvalued or undervalued," he said. "Second, you
can't fight market forces, so talking about it won't do any good. And third,
anything you say is likely to backfire and hurt your credibility. People will
realize you don't know any more than anybody else."
I had to admit that all of those things were true. But I still didn't agree
that raising the issue in public was necessarily a bad idea. The growing importance
of the stock market was impossible to deny. How could you talk
about the economy without mentioning the eight-hundred-pound gorilla?
While the Fed had no explicit mandate to focus on the stock market, the
effects of the run-up in prices seemed to me a legitimate concern. In quelling
inflation, we had established that price stability is central to long-term
economic growth. (In fact, one major factor causing stock prices to rise was
investors' growing confidence that stability would continue.)
Yet the concept of price stability wasn't as self-evident as it seemed.
There were probably ten different statistical series on prices you could look
at. For most economists, price stability referred to product prices—the cost
of a pair of socks or a quart of milk. But what about the prices of income-
earning assets, like stocks or real estate? What if those prices were to inflate
and become unstable? Shouldn't we worry about the price stability of nest
eggs and not just the eggs you buy at the grocery store? It wasn't that I
wanted to stand up and shout, "The stock market is overvalued and it will
lead to no good." I didn't believe that. But I thought it important to put the
issue on the table.
175
THE AGE OF TURBULENCE
The concept of irrational exuberance came to me in the bathtub one
morning as I was writing a speech. To this day, the bathtub is where I get
many of my best ideas. My assistants have gotten used to typing from drafts
scrawled on damp yellow pads—a chore that got much easier once we
found a kind of pen whose ink doesn't run. Immersed in my bath, I'm as
happy as Archimedes as I contemplate the world.
After the Dow had broken 6,000, in mid-October 1996, I'd begun
looking for an opportunity to speak up about asset values. I decided that
the American Enterprise Institute's annual dinner on December 5, where
I'd agreed to give the keynote address, would be perfect. It's a major black-
tie affair that attracts more than a thousand people, including many Washington
public policy experts, and it comes early enough in the holiday
season to count as a serious event.
To put the stock-market question in proper perspective, I thought I
should embed it in a capsule history of U.S. central banking. I reached all
the way back to Alexander Hamilton and William Jennings Bryan and
worked my way up to the present and the future. (A more general audience
might have been put off by the wonkiness of this approach, but it was
about the right speed for the American Enterprise Institute crowd.)
I wrote the speech so that the issue of asset values accounted for only
a dozen sentences toward the end, and I carefully hedged what I had to say
in my usual Fedspeak. Yet when I showed the text to Alice Rivlin on the
day of the speech, "irrational exuberance" jumped right out at her. "Are you
sure you want to say this?" she asked.
On the podium that night, I delivered the key passage, watching carefully
to see how people would react. "As we move into the twenty-first
century," I said, referring to the Fed,
the Congress willing, we will remain as the guardian of the pur
chasing power of the dollar. But one factor that will continue to
complicate that task is the increasing difficulty of pinning down
the notion of what constitutes a stable general price level. .. .
Where do we draw the line on what prices matter? Certainly
prices of goods and services now being produced—our basic mea
sure of inflation—matter. But what about futures prices? Or more
176
IRRATIONAL EXUBERANCE
importantly, prices of claims on future goods and services, like equities,
real estate, or other earning assets? Is stability of these prices
essential to the stability of the economy?
Clearly, sustained low inflation implies less uncertainty about
the future, and lower risk premiums imply higher prices of stocks
and other earning assets. We can see that in the inverse relationship
exhibited by price/earnings ratios and the rate of inflation in
the past.
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?
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. But
we should not underestimate, or become complacent about, the
complexity of the interactions of asset markets and the economy.
Admittedly, this was not Shakespeare. It was pretty hard to process, especially
if you'd had a drink or two during the cocktail hour and were hungry
for dinner to be served. When I came back to the table, I whispered to
Andrea and the others seated there, "What part of that do you think will
make news?" No one guessed. But I'd seen people in the audience sit up
and take notice, and as the evening ended, the buzz began. "Fed Chairman
Pops the Big Question: Is the Market Too High?" wrote the Wall Street Journal
the next day; "Irrational Exuberance Denounced," said the Philadelphia
Inquirer; "A Buried Message Loudly Heard," said the New York Times. "Irrational
exuberance" was on its way to becoming a catchphrase of the boom.
But the stock market did not slow down—which only reinforced my
concern. It's true that my remarks initially caused a sell-off around the
world, partly on the suspicion that the Fed would immediately raise rates.
Stock prices fell first in Japan's markets, where it was already morning when
I spoke, then hours later as the markets opened in Europe, and finally in
New York the following day. On the New York Stock Exchange, the Dow
177
THE AGE OF TURBULENCE
dropped almost 150 points at the opening bell. But by afternoon the U.S.
markets had bounced back, and after one more trading day they had regained
all the lost ground. America's stock markets ended the year up by
well over 20 percent.
A
A
nd the bull charged on. The Dow Jones Industrial Average was al
ready nearing 7,000 when the FOMC convened for the first time in
1997, on February 4. By then I knew from private conversations with many
of the governors and bank presidents that the committee shared my worry
that the development of a stock bubble might cause inflationary instability.
Apart from the run-up in the stock market, the economy was as robust as
it had been six months before, when I'd resisted the idea of tightening rates.
But my concern about a bubble had changed my mind. I told the commit
tee we might need an interest rate increase to try to rein in the bull. "We
have to start thinking about some form of preemptive move," I said, "and
how to communicate that."
I was choosing my words very carefully because we were on the record
and we were playing with political dynamite. The Fed has no explicit man
date under the law to try to contain a stock-market bubble. Indirectly we
had the authority to do so, if we believed stock prices were creating infla
tionary pressures. But in this instance, that would have been a very hard
case to make because the economy was performing so well.
The Fed does not operate in a vacuum. If we raised rates and gave as a
reason that we wanted to rein in the stock market, it would have provoked
a political firestorm. We'd have been accused of hurting the little investor,
sabotaging people's retirements. I could imagine the grilling I'd get in the
next congressional oversight hearing.
All the same, we agreed that trying to avoid a bubble was consistent
with our mission, and that it was our duty to take the chance. I mused
aloud in our meeting that day, "We need above all to make certain that we
keep inflation low, risk premiums low, the cost of capital low.... If we are
talking about long-term equilibrium, high market values are better than
low market values. What we are trying to avoid is bubbles that break, vola
tility, and the like." With the committee's consent, I hinted at an impending
178
IRRATIONAL EXUBERANCE
rate hike in my public remarks over the next several weeks. This was to
keep from shocking the markets with an abrupt move. Then we met again
on March 25 and raised short-term rates by 0.25 percent, to 5.5 percent.
I wrote the FOMC's statement announcing the decision myself. It talked
purely in terms of the Fed's wish to address underlying economic forces
that threatened to create inflation, and did not say a word about asset values
or stocks. As I described the rate increase shortly afterward in a speech,
"We took a small step to increase the odds that the good performance of
the economy can continue."
In late March and early April of 1997, right after our meeting, the Dow
dipped by some 7 percent. This represented a loss of almost 500 points, to
some minds a delayed reaction to our rate hike. But within a few weeks, the
momentum shifted and the market came roaring back. It recouped all of
its losses and gained 10 percent more, so that by mid-June, it was nearing
7,800. In effect, investors were teaching the Fed a lesson. Bob Rubin was
