NCPA - National Center for Policy Analysis

Markets Don't Create Bubbles -- But Government Can Prick Them

April 5, 2000

Liberals baffled by the stock market's huge run-up have been arguing that the stock market is in the midst of a great bubble that is bound to burst. A bubble is a vast increase in asset prices supported by nothing but mob psychology. However, careful historical research has failed to find any case where a real bubble actually existed.

Even the famous "tulipmania" episode of 17th century Holland was not a bubble, according to Brown University economist Peter Garber -- only in the last few weeks of the tulip craze, when some bulbs sold for $50,000, were prices divorced from fundamentals.

There have been significant market crashes; but such market revaluations show only that new information -- usually policy changes by government -- caused estimates of future profits to be too high.

For two years prior to the 1929 crash the Federal Reserve had directly targeted the stock market, which it believed was unsustainably high. It raised interest rates and restricted credit to the point where even a modest threat to future profits caused a massive decline in asset prices.

Yale University economist Robert Shiller, a bubble theory advocate, writes in his new book, "Irrational Exuberance" (Princeton University Press), that "The Great Depression of the 1930s was in fact substantially due to monetary authorities' trying to stabilize speculative markets through interest rate policies."

What we call bubbles are often simply manifestations of excessively loose monetary policies. When the monetary authorities tighten money to control inflation, asset prices must necessarily go down. The ultimate fault lies with central banks for failing to maintain a noninflationary monetary policy.

Absent such mistakes there is no reason to think that previous market valuations could not have been maintained indefinitely.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, April 5, 2000.


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