The Beginning of Irrational Exuberance

On this day in economic and financial history. . .

The phrase "irrational exuberance" first entered the economic lexicon on Dec. 5, 1996, in a speech by Alan Greenspan, then the chairman of the Federal Reserve:

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? 

Greenspan's evening speech to the American Enterprise Institute led to immediate market slumps around the world. Japan's leading index dropped by more than 3% when it next opened, Germany's market declined by 4%, Hong Kong was down by nearly 3%, and London traders suffered a 2% market decline. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) dropped by 2% within the first 30 minutes of trading, but finished essentially flat by the end of the day.

This minor panic was fleeting. The Dow rose 28% within a year of Greenspan's comments, and two years later its total gain stood at 41%. By the end of 2000, at the height of the dot-com bubble, "irrational exuberance" had been all but forgotten, and the Dow had risen an astounding 71% in four short years. However, just four years after the first mention of irrational exuberance, Greenspan was very belatedly proven correct, and the Dow began a decline that would cut its value from nearly 12,000 points to a low of 7,286 points -- which was still 13% higher than its Dec. 5, 1996, closing value of 6,437 points. The dot-com meltdown was accurately predicted by Yale economist and eventual Nobel winner Robert Shiller in a book titled Irrational Exuberance, which was published in spring 2000 just as the decline began. It was later updated in 2005 to discuss the inflating housing bubble, which blew apart about two years after the revised book's publication.

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