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As a rule we favour capitalism in an expansion and socialism in a contraction.
— George Cooper

“You know we need to de-addict,” she said, late one night as I finished reading and was about to call it a day.
“De-addict? Well, I have moved on from coffee to green tea…” I remarked, switching off the reading light.
“Stop joking. What I meant was we have been spending too much time
together.”
“So?” I asked, senses on full alert.
“We are getting addicted to each other.”
“Isn’t that the idea, my dear?” I asked.
“I am not sure of that. Addictions can be dangerous.”
I didn’t like the way this conversation was going and decided I had to wean her away from the topic. “You know, I have been thinking,” I said.
“About what?”
“On December 5, 1996, nearly 13 years ago, Alan Greenspan, the then chairman of the Federal Reserve, the central bank of the US, made a speech.”
“Stop. Where did Greenspan come in from? We were talking about de-addiction.”

“Hold on, we will come back to that. So in this speech Greenspan used the phrase ‘irrational exuberance’ once, purportedly to describe the state of the stock markets around the world and its investors. The stock markets around the world were rallying at that point of time. As soon as Greenspan uttered those words, the markets fell. The Nikkei index in Japan fell by 3.2%. The DAX index in Germany fell by 4%. The FTSE index in London was also down by 4%. The Hang-Seng index in Hong Kong came down by 2.9%. Next morning, the Dow Jones Industrial Average, a premier US stock market index, opened 2.3% lower.”

“But what exactly did Greenspan say?”
“In the middle of what was a terribly boring speech, Greenspan said this: ‘But how do we know when irrational exuberance has unduly escalated asset values.’ And the stock markets started around the world started to tumble.”

“Wait a minute, now. Greenspan never said markets were irrationally exuberant or overvalued. Then why did stock markets take a tumble?” she asked. I knew I had successfully hijacked the conversation.

“Well, central bank governors rarely make direct statements. They drop hints and the markets react to those hints. That’s the way it works. So anyway, the markets fell after the statement, then they recovered and kept going up till around March 2000. After that, Greenspan did not make any such statements. Between 1998 and 2000, the technology and dotcom stocks in the US went up big time. This period is referred to as the dotcom bubble. Greenspan let this bubble run by keeping the interest rates almost flat between 1995 and 2000. By the time he started raising interest rates in late 1999, the Nasdaq, a stock exchange on which most of the IT stocks were listed, was well past its previous highs.”

“Hmmm. But why didn’t he start raising interest rates earlier to prick the dotcom bubble sooner?”“That is an intelligent question. To answer that, we will have to get a little into economic theory. See, economists over the last hundred years have believed in what is known as the efficient market theory. This theory says that assets, at any point of time, are always correctly valued. Take the example of a stock. The theory says the price of that stock at any point of time reflects all the information available and is the correct price of the stock. Any movement in price from there on will happen only when new information comes in. This is the premise on which most modern economics is based.”

“But what does this mean for central bankers like Greenspan?” “Well, the policies followed depend on the prevailing economic thought. And if the prevailing economic thought believes stock markets are correctly valued at any point of time, then a logical corollary as per this theory is that there are no asset price bubbles or bust.

As George Cooper highlights in The Origin of Financial Crises - Central Banks, Credit Bubbles and the Efficient Market Fallacy, “Under this theory, the wild asset price swings commonly referred to as bubbles are nothing more than markets responding to changing fundamentals… To these researchers, the Nasdaq Composite Index was correctly priced at 1,140 in March 1996, also correctly priced at 5,048 in March 2000, and again correctly priced when, in October 2002, it had returned to a price of 1,140.”

“But you still haven’t answered my question… what does this mean for Greenspan and his ilk?”“I was about to come to that. A belief in efficient market theory encourages central bankers to follow a principal of laissez-faire, which argues that market forces be given a free rein. The logic is to let the markets sort themselves to a level of equilibrium. As Cooper writes, ‘The idea that markets are always correctly priced remains a key argument against central banks attempting to prick asset price bubbles.’

And they simply let them run, till these bubbles become a systemic risk and need to be pricked by raising interest rates. The irony is that the belief in efficient markets is put by the wayside the moment asset prices begin to fall. To quote Cooper, ‘Strangely, however, when asset prices begin falling, the new lower prices are immediately recognised as being somehow wrong and requiring corrective action on the part of policymakers,’” I explained.

“And what is this corrective action?”
“The corrective action is cutting interest rates, so that people start borrowing again. In the aftermath of the dotcom bubble going bust, Greenspan, as chairman of the Fed, started to cut interest rates. In fact, he started cutting interest rates very aggressively from January 3, 2001, when there was not much evidence of an upcoming recession. And the interest rate was cut to as low as 1% by mid-2003, where it stayed for around 12 months. These lower interest rates fuelled the housing bubble in the US and other parts of the world.