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POLICY INSIGHT No.97 October 2019 abcd POLICY INSIGHT No.97 October 2019 Herd behaviour in asset market booms and crashes: the role of monetary policy Stefano Micossi*, Alexandra D’Onofrio** and Fabrizia Peirce* *Assonime; **Arcelli Center for Monetary and Financial Studies obert Shiller’s influential book “Irrational feature of manias. Section 3 shows that not all Exuberance” (Shiller 2015) dealt powerful asset price bubbles turn into manias; it then Rblows to the hypothesis of efficient capital describes the build-up of financial imbalances and markets by describing in remarkable detail the deep- the paper pyramids underlying the unfolding of rooted psychological and ‘irrational’ mechanisms manias, notably including the interaction between driving investors’ decisions, on occasion developing real estate bubbles, on the one hand, and bond into herd behaviour – ‘manias’ – and generating and stock price increases, on the other, in cross- ‘bubbles’ in housing, bond and stock markets. One feeding financial excesses. Section 4 discusses the important conclusion of his work is that bubbles role of monetary policy in turning bubbles into and manias are random exogenous phenomena manias, by offering an anchor to the convergence that cannot be foreseen or, for that matter, of investors’ expectation of ever higher gains. explained by standard macro-economic analysis Section 5 summarises our conclusions. and, more specifically, do not depend on macro- economic policies. This view has been subscribed to by many influential scholars of financial crises, Bubbles and manias such as Blinder (2013) and Bernanke (2015). The standard definition of an asset price bubble is Experience has repeatedly confirmed that, once a large and long-lasting deviation of the price of bloated asset prices stop rising, they do not stand some assets – such as a stock, a bond or a house still but fall precipitously, occasionally, but not – from their fundamental value, which is the always, leading to widespread bankruptcies, bank expected discounted income or other benefit and crises and economic depression. Therefore, Shiller’s valuation increase over the holding time-horizon conclusions are important for understanding the (Kindleberger & Aliber 2005; Blinder 2013). root-causes of financial crises and the resulting depressions, and hence our ability to build effective While the definition is conceptually clear, in defences against their repetition. practice it is very difficult to identify a bubble: what may appear ex-post as a bubble, after an In this paper, we argue that Shiller may be ensuing price crash, may have been seen ex-ante overlooking the role that lax monetary policy plays as a rational investment by many sophisticated in triggering financial bubbles and manias, notably investors. Peter Garber (2000), for instance, by offering to investors’ expectations a perverse famously argued that even the tulip mania in the anchor of ever-increasing asset prices. To this end, Netherlands in the early 17th century was rational, we will review the two financial bubbles and the more or less in line with what happens with ensuing crashes in the United States during the other rare objects craved by collectors. While his 1920s and 2000s, drawing attention to the possible arguments are not fully convincing (cf. Chancellor destabilizing role of the Federal Reserve, which not 1999, Shiller 2015), they point to the wide margins only maintained a highly expansionary monetary of appreciation involved in any attempt at judging policy stance as asset prices perilously accelerated, the fundamental value of an asset. This argument but also promised investors that their expansionary played an important role in convincing Alan stance would be maintained indefinitely. Greenspan, then Chairman of the Federal Reserve, that it was none of his business to try to stop an The paper is organized as follows. In Section 2 emerging asset bubble (Greenspan 2007). we define bubbles and manias and show that the convergence of investors’ expectations of ever Shiller (2015), on the other hand, offers many higher gains may be taken as the distinguishing examples of ‘obvious mispricing’ of real and CEPR POLICY INSIGHT No. 97 CEPR POLICY INSIGHT No. To download this and other Policy Insights, visit www.cepr.org OCTOBER 2019 2 Chart 1. Stock prices and investors’ perceptions (monthly data, 1991-2012) % Investors percep�ons* Real S&P 500 Composite Stock Price Index (right scale) 100 3000 90 2500 80 2000 70 1500 60 1000 50 500 40 30 0 *Percentage of investors believing market is not too high. Source: Shiller financial assets, sometimes lasting a long time. paying the highest price ever for an office building His empirical evidence leads him to conclude (Kindleberger & Aliber 2005). that “stock prices clearly have a life of their own; they are not simply responding to earnings or Charles Mackay – who provided the first dividends. … In seeking explanations of stock price popular account of the Tulip mania and the movements, we must look elsewhere” (p. 208). Mississippi and South Sea bubbles in his book He maintains that these other factors are mainly Extraordinary Popular Delusions and the madness psychological and not related to policy actions; of crowds (1841) – described speculative manias therefore, he somehow agrees with Greenspan that as a “manifestation of the occasional tendency macro-financial policies are not the right tool to of societies to succumb to delusion and mass prevent asset mispricing. madness” (quoted by Chancellor 1999: xiii). In his classical work on the Great Depression, Galbraith Manias may be characterized as a general (1954: 99) noted that “by the summer of 1929 the atmosphere of euphoria, simultaneously boosting [stock] market not only dominated the news. It also asset prices, consumption and investment dominated the culture”. He described how simple spending, and the broad participation of all social people, even housewives normally excluded from layers in the speculative wave. Typically, spending trading on the exchange, became active investors. surges because credit is plentiful and ready to Shiller (2015) offers rich evidence to confirm accommodate most extravagant undertakings. that this was indeed a widespread phenomenon Thus, in the past century, real estate bubbles both in 1928-1929 and in 2007-2008. Akerlof & were repeatedly and significantly related to the Shiller (2009: 65) provide a fitting description of multiplication of super-skyscrapers. With the real a mania, which they dub an overheated economy, estate bubble in full swing in Japan in the second “a situation in which confidence has gone beyond half of the 1980s, the Mitsui Real Estate company normal bounds, in which an increasing number of paid US $625 million for the Exxon Building in people have lost their normal scepticism about the New York (its initial asking price had been $325 economic outlook and are ready to believe stories million), their motivation being that they wanted about a new economic boom”. to get into the Guinness Book of World Records for CEPR POLICY INSIGHT No. 97 CEPR POLICY INSIGHT No. To download this and other Policy Insights, visit www.cepr.org OCTOBER 2019 3 Shiller himself has built a data set (available since Chapter 8), seeking evidence of potential bubbles, the early 1990s) on investors’ expectations of stock while Kindleberger & Aliber (2005) devote special price developments that may help us distinguish attention to the two episodes in the late 1920s and more precisely a stock market bubble from a mania.1 2000s, which they consider the sole examples of In Chart 1 a main stock market price index2 has manias. been depicted, together with Shiller’s measure of investors’ perception of current stock prices, i.e. the To an extent, their different approaches reflect percentage of investors expecting prices to go up, different research questions. Shiller is looking for over the January 1991 – September 2012 period. evidence of irrational behaviour, identified by persistent and lasting deviations of stock prices As Chart 1 demonstrates, once stock prices from their fundamental value. His conclusion is started to rise since the mid-1990s, the share of that stock prices, while being in general highly investors considering them likely to increase variable, display “quite a substantial, though further diminished steadily and reached its imperfect, tendency for major five-year stock price trough more or less at the time of the market movements to be reversed in another five years, peak. As may be recalled, this was the period of for both up movements and down movements” the so-called dot.com bubble, when the price of IT (p. 161), indicating the likelihood that they had stocks rose to unbelievable heights before falling previously moved too far. His general picture is one back in the following two years. The behaviour in which stock markets on occasion run too high, of the expectation curve seems to point to an reflecting exogenous events that are temporarily environment in which investors’ opinions differ amplified by investors’ self-fulfilling psychology and do not move in herd. (‘emotions’) and are not explained either by fundamental values or macro-polices. Blinder Compare this with the behaviour of investors’ (2013) takes the same view; he accordingly concurs expectations in the ensuing period up to 2008, with Shiller that the real estate boom of the 2000s when stock prices recovered to lesser heights, cannot be explained by the lax monetary policy but in a frenetic environment not dissimilar that followed the implosion of the dot.com bubble to that observed in the late 1920s. One can since, as he argues, the house price increase had see that, sometime after 2003, a rising share already taken off in the mid-1990s. of investors start expecting prices to continue going up despite already substantial increases, Kindleberger & Aliber (2005) on the other hand, and that the phenomenon of convergence in point out that, after imploding, certain waves of expectations persists in 2009 even after stock asset price increase subsequently lead to much prices turn downward rather dramatically.
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