The Myth of Irrational Exuberance

Publication Date

September 2009

Author(s)

Roberto G. Quercia

Much has been written about the causes of the foreclosure crisis. Blame has been placed on everyone from irresponsible homeowners to greedy real estate agents, appraisers, and lenders, to  sloppy investors, to apathetic government regulators. Others have blamed a “boom psychology,” contending that market participants got carried away by a collective and irrational belief in never-ending house price appreciation. This view is the most recent incantation of Alan  Greenspan’s now famous expression, “irrational exuberance.”

In his 2008 book, The Subprime Solution, Robert J. Shiller sees boom thinking as the main cause of today’s mortgage foreclosure crisis, as he writes that: “…the most important single element to be reckoned with in understanding this or any other speculative boom is the social contagion of boom thinking.”

We do not accept the premise that the global financial crisis was rooted in some sort of mass delusion. Instead, we contend that the major cause was very real: market participants acting in a  rational manner in response to short term economic incentives led to the boom and subsequent bust in housing markets, the credit crisis, and the deep recession. If anything, it was the meteoric growth in risky lending that fueled the run up in prices, affecting the psychology of market participants along the way.

Why is this important? If the key causes of the crisis were “irrational” and “psychological” there is little to be done except hope for more sober behavior next time. In contrast, if the key cause was real economic incentives, as we contend it was, then action to change these incentives is justified.

If the market as currently structured is unable to police itself, it is clear that the regulatory structure needs to change. Who will assume this responsibility — whether a committee of regulators or a single regulator (and which one) — is currently in debate. More importantly, how and what they regulate should address the concrete causes of the crisis.