Irrational Exuberance

Irrational exuberance was a term Greenspan used to demonstrate the speculative bubbles that occurred throughout the economy.  Robert Schiller used this phrase as the title to his very influential book Irrational Exuberance.  The term was invented by Greenspan while he addressed the AEI in Washington DC. 

“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?” 

                                                            -Alan Greenspan

The term addresses a fascinating discipline named behavioral economics.  Unfortunately it is a field in embryonic stages, and it is complicated interdisciplinary field that encompasses many schools of thought.  Economists and psychologists use models developed in this field to attempt to understand why irrational and rational decisions are made.  In Schiller’s work he examines why bubbles persist throughout markets.  His work focused on the stock market bubble that was the tech boom.  However his work can be applied to the housing bubble that is deflating as I write, more importantly can identify the recent commodity bubble.  Individuals will site supply and demand as the reason that oil is now at 140 dollars a barrel.  That is part of the equation yet such a large increase in price can be attributed to numerous factors.  One of the reasons for oil’s price is speculators, who are manifesting irrational exuberance.  Don’t expect any one to cry for them when the bubble pops.  Why does it happen, why are we continually drawn into irrational decisions in search of profits?  Want the answer read Schiller’s book, it will only help you as a trader.

On the other hand we seem to have a pattern of shifting bubbles.  Why do assets seem to leap from one bubble to the next in search of profits?  We started with the tech bubble then the housing bubble then the commodity bubble.  Where the next bubble will occur?  FX, perhaps.  Just look at the dollars decent over the past five years.  Could this be defined a bubble?  Absolutely the exchange rate is an asset price, so why not.  Bubbles are natural they occur, just try to be prudent and avoid them.  Accept that the Euro is at 1.60 and this level is unsustainable in the long run.  Understand however that in the short run irrational exuberance may overrule rationale prudence.