Herd Behaviour in Asset Markets: The Role of Monetary Policy

This is Naked Capitalism fundraising week. 1409 donors have already invested in our efforts to combat corruption and predatory conduct, particularly in the financial realm. Please join us and participate via our donation page, which shows how to give via check, credit card, debit card, or PayPal. Read about why we’re doing this fundraiser and what we’ve accomplished in the last year, and our current goal, more original reporting.

Yves here. Since I suspect many of you read earlier editions of Robert Shiller’s Irrational Exuberance, it would be nice if somewhere the author of the post acknowledged that (both the 5 and the 2015 new editions added topics and updates). I reviewed the original edition in 2000. We discussed Greenspan in that piece, and interestingly, Stefano Micossi explicitly discusses the role of the Greenspan put. In ECONNED, we fingered overly lax monetary policy in the dot-com bust era and the Greenspan (and later Bernanke) put as contributors to the crisis.

This post, however, draws a useful distinction between a bubble and a mania.

By Stefano Micossi, Director General, ASSONIME; Honorary Professor College of Europe; Member of the Board of Directors of Unicredit and chairman of the Board Committee for Corporate Governance, Nomination and Sustainability; Chairman of the School of European Political Economy, LUISS. Originally published at VoxEU

Robert Shiller’s influential book, Irrational Exuberance(Shiller 2015), dealt powerful blows to the hypothesis of efficient capital markets by describing in remarkable detail the psychological (‘irrational’) mechanisms driving investors’ decisions. One important conclusion of his work is that bubbles are random exogenous phenomena that cannot be foreseen and do not depend on macroeconomic policies. In a new CEPR Policy Insight, Alessandra D’Onofrio, Fabrizia Peirce and I throw light on the root causes of speculative fevers in asset markets and related financial booms and busts (Micossi et al. 2019). We show empirical evidence indicating that Shiller may have overlooked the role that lax monetary policy played in triggering financial bubbles in the 2000s by offering investors a perverse promise of ever-increasing asset prices.

Bubbles and Manias

The standard definition of an asset price bubble is a large and long-lasting deviation of the price of some assets – such as a stock, a bond or a house – from their ‘fundamental value’, which is the expected discounted income or other benefit and valuation increase over the holding time-horizon (Kindleberger and Aliber 2005, Blinder 2013). While the definition is conceptually clear, in practice it is very difficult to identify a bubble. What may appear ex post as a bubble, after an ensuing price crash, may have been seen ex ante as a rational investment by many sophisticated investors.

Manias are a broader phenomenon that may be characterised as a general atmosphere of euphoria, simultaneously boosting asset prices, consumption and investment spending, and the broad participation of all social layers in the speculative wave. Typically, spending surges because credit is plentiful and ready to accommodate most extravagant undertakings. Thus, in the past century, real estate bubbles were repeatedly and significantly related to the multiplication of super-skyscrapers.

Figure 1 – based on data built by Shiller himself – offers a useful basis to distinguish bubbles from manias. It depicts a main stock market price index together with Shiller’s measure of investors’ expectations on the future evolution of current stock prices. As may be seen, the rapid rise in stock market prices since the mid-1990s, up until the peak in 2000, went along with a declining share of investors expecting further price rises, indicating that investors maintained healthy differences of opinion. On the other hand, starting in 2003 rising stock prices seemingly go together a rising share of investors expecting further price increases. This convergence in investors’ expectations may be taken as the distinguishing feature of manias, whereby not only do stock prices lose contact with underlying fundamental values but also an increasing number of investors start dreaming of ever-increasing prices of a broad range of assets.

Figure 1 Stock prices and investors’ perceptions (monthly data, 1991-2012)

Note: * Percentage of investors believing market is not too high.
Source: Shiller.

This distinction is useful in order to appreciate the quality and the consequences of financial excesses, whereby bubbles are frequent but less harmful, while manias are rarer but lead to more dramatic dislocations in the financial system and the real economy. Shiller (2015) tables 25 episodes of extraordinary stock price increase and decrease (over one-year and five-year time horizons) in the three decades from the 1970s to the 1990s, which he sees as random and unpredictable events. Kindleberger and Aliber (2005) devote special attention to the two episodes, in the late 1920s and 2000s, which they consider the sole examples of manias and which were followed by much deeper financial dislocations and economic depressions. In their view, bubbles and manias are monetary phenomena, liable to be explained by massive excess liquidity.

When Investors Go Crazy

In the 1950s Hyman Minsky developed a theory of financial instability – centred on the procyclical role of credit supply – that fits pretty well the events that, in 2008-09, led the capital markets in the main financial centres to a near meltdown (Minsky 1984). During the expansion phase, investors revise upwards the expected profitability of a wide range of investments and accordingly raise their demand for credit. At the same time, lenders take an increasingly benign view of the risk of individual investments and become more willing to lend. When economic conditions worsen, both investors and lenders retrench. In this process, the behaviour of heavily indebted borrowers assumes special importance: when the economy slows down and asset prices go into reverse, those who borrowed short to purchase real and financial assets, seeking quick gains from valuation increases, may become distressed sellers and transform the downward price adjustment into a rout.

An important ingredient in the pro-cyclical expansion of credit is a ‘displacement’, i.e. some exogenous shock sufficiently large and pervasive to improve perceived profit opportunities and the economic outlook at least in one important sector of the economy. Kindleberger and Aliber (2005: 64) described how “speculative manias gather speed through expansion of money and credit”, concluding that, while most expansions of credit do not lead to a mania, every mania appears associated with a strong expansion of credit.

Figure 2 sheds further light on the distinction between bubbles and manias, showing that the rising cycles in (US) stock prices build up slowly, over several years and even decades; occasionally, they were interrupted by sharp drops but then resumed in earnest, subsequently reaching new peaks. Another feature worth noting is that the variability of GDP growth has diminished markedly after WWII, while the oscillations in stock prices – relative to earnings – have widened. Both phenomena may be related to the rise in macro-policy activisms; in particular, monetary policy was used aggressively to cushion stock market falls and their impact on economic activity, indeed more aggressively over time.

Figure 2 US price/earnings ratio and GDP growth (1880-2012)

Sources: Shiller and Conference Board. 

For the two major financial crises highlighted in Figure 2, stocks, bonds and real estate markets were all part of the same madness. As prices rose rapidly, increasing shares of the population became involved, hoping to partake in the enormous gains seemingly at hand and compounding mounting financial imbalances with their leveraged investments. The interconnections between intermediaries and markets aggravated the subsequent financial crises, as well the fall in economic activity.

Monetary Policy Anchors for Investors’ Expectations

As already mentioned, Shiller (2015) attributed the acceleration of price rises for houses and other assets in the decade between the late 1990s and 2006-2007 to psychological factors. Blinder (2013) similarly believed that several factors had been at work in the house price boom among which he saw monetary policy as only “a minor contributor to the boom”. Bernanke (2015) also discusses the same matter extensively. He acknowledged that many Fed Board members, including himself, had underestimated the extent of the housing bubble and the risks it posed but belittled the role of monetary policy in generating the boom.

The view that monetary policy did not play an important role in the asset market boom of the second half of the 2000s appears at odds with Greenspan’s account of events in his memoirs (Greenspan 2007). He describes at length how lower interest rates in credit markets boosted demand for residential real estate and pushed their prices higher and higher through 2006, with new constructions but also secondary sales surging to unprecedented heights; and how the real estate boom fuelled the associated consumption spree.

More important, the Fed’s pattern of not intervening when stock prices were rising, while providing ample liquidity to support the market when stock prices fell, resulted in the investors’ perception of a ‘put’ protection on asset prices – the famous ‘Greenspan put’. Investors increasingly believed that in a crisis or downturn, the Fed would step in and inject liquidity until the problem improved. As the Fed did so repeatedly, that perception became firmly embedded in asset prices in the form of higher valuation, narrower credit spreads, and excess risk taking.

And indeed, as may be seen in Figure 1, the first large upward jump in the 2000s in the investors’ expectation curve coincides with the early phase of the Fed expansion, in 2002 and 2003; further jumps accompanied the continuing rise in the stock price index, as monetary policy was tightened moderately, but never enough to dampen the speculative fever. Euphoria found further fuel when Bernanke stepped in as Chairman of the Fed Board and confirmed his predecessor’s policy approach.

Comparison with the experience of the 1920s provides some confirmation for this interpretation. A similar event to the ‘Greenspan put’ may then have been the visit to New York, in 1928, by three prominent European central bankers who managed to convince the Federal Reserve that looser monetary conditions in the US were essential for preserving the Gold Standard internationally. The message to investors was clear. The Fed would be constrained not to raise interest rates for an indeterminate future. According to Professor Lionel Robbins “from that date, according to all evidence, the situation got completely out of control” (quoted in Galbraith, 1954: 39).

See original post for references

Print Friendly, PDF & Email


  1. monday1929

    And of course Mr Robert Prechter’s seminal contributions to this topic are ignored.
    The skyscrapers, easy money and public willingness to speculate (or not) are all related to the same shared “SOCIAL MOOD” (zeitgiest/tenor of the times etc).
    Only Prechter predicted the secessionist movements, increasing polarity, building of walls etc.
    The only anomaly is that trump should have been elected at a stock market bottom, not near a peak.

    1. ObjectiveFunction

      Ha ha, so Trump is the elites’ equivalent to Asimov’s “Mule”, the one who wasn’t predicted in the plan.

      There’s anecdotal evidence to show that was indeed Trump’s expectation in 2016: to lose narrowly to Herself, let the bubbles pop on her watch and then be swept in in 2020 as the savior figure.

      As the short sellers say, the consequences of being right too early are often worse than those of being wrong. Ripeness is all….

  2. eg

    This analysis suggests to me that a return to “credit guidance” may be in order — effectively different interest rates for different sectors of the economy.

    Capital controls are also probably a good idea.

    1. JTMcPhee

      Isn’t that how credit works already? The mopes at the bottom pay rack rent rates on payday loans, up into the thousands of percent interest, and if they can “qualify” for a credit card, the mope is facing up to 22.9% as long as s/he is current, but more like 30%+ if late. https://www.valuepenguin.com/average-credit-card-interest-rates Banksters, on the other hand, pay A lot less for their borrowings. I’m guessing there’s a similar sorting for small and large businesses. And can hire lawyers and accountants to hide or transfer their assets to avoid liquidation.

      And thanks in part to Joe “lovable guy” Biden, the Banksters and corps and private equity types can disappear their debts in a bankruptcy discharge, while the mope who goes crushed by medical debt or student loans or other misfortunes faces a steeper hill.

  3. Chauncey Gardiner

    While material, I feel this is but one facet of several pertaining to the role of monetary policy in asset markets. For example, an aspect of current equity and debt markets is that largely as a result of debt-funded acquisitions, Private Equity firms now own over 8,000 corporations, while fewer than 4,400 corporations now have shares outstanding that are publicly traded on the market exchanges, a decline of 46% since 1996.

    Private equity firms benefit from low or negative real interest rates that enable them to borrow and service the debts incurred in highly debt-leveraged buyouts of companies, enjoy gains on sales of assets stripped from the companies they buy, increase the reported profits of their portfolio companies, and value their portfolio companies based on high share prices of “comparable” publicly traded companies in the valuations they report to their own investors. And the large private equity firms are extremely well connected politically.

    Regarding publicly traded companies, massive corporate share buybacks that have been largely funded with debt have also fueled increased share prices. These factors are well beyond considerations pertaining to the psychology of individual investors who buy and speculate in securities and real estate using debt and benefit financially from low interest rates on that debt.

  4. Peter Dorman

    I’m not an expert in monetary history, so I won’t try to evaluate the narrative aspect of this post—the story it tells about monetary policy and bubble buildup during the 00’s. Here are a few general comments though:

    1. The housing bubble had global reach under a variety of policy regimes. Spain’s was worse than the US’, and there was no implicit put in ECB policy.

    2. Credit supply is endogenous; it reflects demand as well as policy choice by institutions on the supply side. The article doesn’t begin to address this. Correlation is *way* different than causation in such a situation.

    3. I dislike the definitions of bubbles and manias because I think they muddy the causal processes.

    a. Bubbles are sustained price increases in a commodity predicated on the belief that prices will continue to rise, generating capital gains. Bubbles can be rational at the individual level even if they are irrational at the social level.

    b. Manias, like the converse Keynes/Shiller collapse of animal spirits, are the product of the interactive nature of human communication, which generates multiple equilibria. Standard economic rationality (of the game theory variety) doesn’t serve as a filter in such situations; i.e. it doesn’t rank among equilibrium outcomes.

    The reason I bring this up is that explanations for these phenomena should be predicated on the specific causal processes that bring them about.

    4. To the extent that credit supply was a factor, and I think it was, it was largely the result of global imbalances. That mechanism is clearest for a country like Spain, but it was also apparent in the US. I won’t rehash the old argument, which I’ve written about elsewhere, but my view is that the driving force behind the imbalances was the trade account, not the capital account (net investment flows) as assumed by nearly all mainstream analysts (including Paul Krugman). (And anyway the latent factors behind both are long run and structural and have little to do with marginal adjustments in the fed funds rate.)

    I will admit I am biased against arguments like the OP because I am in favor of permanently low interest rates, regulating the economy fiscally and through regulation. I’m reluctant to agree to higher interest rates in order to suppress bubbles, support pensioners, etc. There’s got to be a better way.

    1. Susan the other`

      Thank you for this comment PD. I agree with your last paragraph. The diff between mania and bubbles, for me, is the diff between denial and confidence, respectively. And to make it all coincide with reality, I think human economic psychology (there should be a faculty) is acutely instinctive. And well in advance.

  5. Sound of the Suburbs

    Many years ago when Alan Greenspan first proposed using monetary policy to control economies, the critics said this was far too broad a brush.

    After the dot.com crash Alan Greenspan loosened monetary policy to get the economy going again. The broad brush effect stoked a housing boom.

    When he tightened interest rates everything came crashing down.


    There were delays while the teaser rate mortgages reset; the new mortgage repayments became unpayable; the defaults and other losses accumulated within the system until everything came crashing down in 2008.

    The broad brush of monetary policy tends to fan out into asset prices.

    It’s always been like that and this is what the critics were warning us about all those years ago.

Comments are closed.