Irrational exuberance and central banks

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The ‘central bank speak’ has become a highly important action of its own. The central bank representative may say a particular word or sentence which could be picked by the media and splashed in newspapers/platforms the next day. In a recent conference, RBI Governor Shaktikanta Das mentioned the word “exuberance” which met a similar fate recently.  As per the Britannica dictionary, the meaning of exuberance is ‘very lively, happy, or energetic: filled with energy and enthusiasm’. How did such a simple word, which means happy, create so much noise in the financial markets and media?

To be more specific, governor Das said that banks and NBFCs (non-bank financial companies) should ensure credit growth at both overall and sectoral levels.  In an earlier article, I had explained how credit growth in the personal loans category has risen significantly over the last decade. The RBI has increased risk weights in personal loans to dampen the growth in the category. Taking note of these developments, the RBI governor added that “all forms of exuberance” are to be avoided.

The word exuberance has deeper connections to central bank speak.

In 1996, former Federal Reserve chair Alan Greenspan mentioned the word irrational exuberance in a speech titled ‘The Challenge of Central Banking in a Democratic Society’. After reviewing the history of money and monetary policy in the United States, Greenspan started discussing future prices of goods, services, financial assets, etc. He said that financial asset bubbles such as the stock market crisis of 1987 did not impact the real economy. However, the central banks should not underestimate the interlinkages between financial markets and real economy and these should be part of monetary policy.

Irrational exuberance

While discussing all these developments, he stated one of the most important words of the central bank lexicon: “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? And how do we factor that assessment into monetary policy?”

These two words ‘irrational exuberance’ created a firestorm in the markets that very day. The financial markets interpreted his words as suggesting that financial assets, particularly stock markets, are overvalued. The stock markets declined across the world immediately after the speech. Having said that, the markets quickly recovered and indices rose, riding the information technology stocks and the boom in the dotcom economy. The irrational exuberance, if there was one, eventually led to a crisis in 2001. Since then, 'irrational exuberance’ has been used as a phrase to suggest bubbles in asset markets.

The phrase ‘irrational exuberance’ became the title of a famous book written by economist Robert Shiller in 2010. Shiller explained that irrational exuberance is the psychological basis of a financial bubble. It starts with news of markets rising (forever) leading to heightened interest among investors. The psychological contagion spreads and draws both, old and new investors. The book actually shows that the period when Greenspan made his speech was one such phase of irrational exuberance. Shiller was later awarded the Nobel Prize in Economics for his work on asset prices, along with Eugene Fama and Lars Peter Hansen.

Both the phrase and the speech on irrational exuberance became so popular that there were discussions on the 20th anniversary and the 25th anniversary of the speech.

Personal loan growth worries

Coming back to RBI speak, governor Das just says exuberance and not irrational exuberance. The RBI has been worried about high growth in personal loans and recently made policies to limit the growth. The banking regulator has learnt lessons of loan exuberance from the global financial crisis of 2008 and India’s banking crisis of 2013-19. Though some may argue that the RBI has acted a tad too late as the high growth was visible for a while now.

Apart from banking, there are signs of exuberance in other financial markets such as equity and in the housing markets. The Indian equity markets have been on a roll for a while now, attracting both old and new investors. Digitalisation has made it really easy to open stock trading accounts leading to a steady rise of demat account holders. Social media has also led to many assuming the role of financial advisers, creating regulatory headaches for SEBI. Stock market experts are constantly feeding the news that Indian markets will touch new heights next year.

On top of all these trends, we are also seeing how retail investors are increasingly entering the derivatives markets. In early 2023, SEBI issued a report where it analysed the trading patterns of retail investors. The report showed that nearly 89 percent of individual traders (i.e., 9 out of 10 individual traders) in the equity derivative segment incurred losses. Concerned about this, SEBI chief Madhabi Puri Buch in a recent speech said that retail investors should avoid investing in derivatives trading for short-term gains which actually are not gains but mostly losses.

In the housing markets, there is this constant stream of news informing how housing prices have risen over the years and are likely to keep rising due to demographics and rising income levels.

Again, quoting Greenspan we do not know whether irrational exuberance has led to high equity or home prices in India. However, quoting Shiller we know that psychological sentiments are fuelling the Indian stock and housing markets. Both RBI and SEBI are acting and cautioning against this exuberance. Only time will tell whether this period was that of irrational exuberance or rational exuberance.

Amol Agrawal teaches at Ahmedabad University, and is the author of ‘History of Private Banking in South Canara district (1906-69)’. Views are personal, and do not represent the stand of this publication.