Irrational Exuberance.

• Author: Greifer, Nicholas
• Position: Review

Schiller, Robert J.

Princeton, New Jersey: Princeton University Press, 2000. (312 pp)

If Irrational Exuberance could be summed up in one sentence, it could be this: "Absurd prices sometimes last a long time."

Amplifying on Federal Reserve Board Chairman Alan Greenspan's now famous remark that the United States stock market investors are in a state of "irrational exuberance," the book tries to document that we are a) in the midst of a market "bubble" where the valuation of the stock market has ballooned since 1982, and b) explain why markets have bubbles from time to time.

In explaining why markets have bubbles, he succeeds in poking holes in the efficient markets hypothesis, which dominates finance. However, what new theory would take its place is not clear (it may be that just a minor alteration in the efficient markets theory is needed). His theory is hard to ascertain, in part because it is deduced much later in the book. On page 167, he summarizes the phenomenon: exogenous factors put in play a media-fueled bubble; stock price increases beget demand for stocks which in turn beget further stock price increases. This describes the mechanics of a bubble, but underlying this relatively rare event are deep psychological forces that usually lie dormant and cause investors to behave irrationally.

The book is structured into five sections, preceded by an opening chapter where he quickly presents the case of an overvalued stock market. The evidence hinges on the fact that prices of stocks are at a historic high in relation to aggregate corporate earnings--indeed, higher than in 1929. While his argument is compelling, it should be noted that bubbles cannot really be known until after the fact. As noted in an interview between the GFOA newsletter Public Investor and Federal Reserve Board Governor Edward Gramlich, "bubbles can never be identified ex ante, only ex post, and we are not sure if there is a bubble out there or not." [1] Thus, it would be useful to strengthen the link in this chapter that high price-earning ratios equate with a market bubble (he does address it much later in the book in the context of whether there has been a broad-based shift in how investors view the risk of stocks). In addition, he implies negative returns on stock investments in the years ahead because of the high price-ear ning ratio. However, he overlooks the "soft-landing" argument--that stocks could still grow, but, say, at 8 percent per year instead of the...