DP3041 Moral Hazard and the US Stock Market: The Idea of a 'Greenspan Put'

Author(s): Marcus Miller , Paul Weller , Lei Zhang

Publication Date: November 2001

Keyword(s): asset bubble , monetary policy , greenspan put , risk premium

JEL(s): D84 , E52 , G12

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3041.asp

The risk premium in the US stock market has fallen far below its historic level, which Shiller (2000) attributes to a bubble driven by psychological factors. As an alternative explanation, we point out that the observed risk premium may be reduced by one-sided intervention policy on the part of the Federal Reserve which leads investors into the erroneous belief that they are insured against downside risk. By allowing for partial credibility and state dependent risk aversion, we show that this ‘insurance’ – referred to as the Greenspan put – is consistent with the observation that implied volatility rises as the market falls. Our bubble, like Shiller’s, involves market psychology: but what we describe is not so much ‘irrational exuberance’ as exaggerated faith in the stabilising power of Mr. Greenspan.