Moral Hazard and the U.s. Stock Market: Analyzing the “greenspan Put”?

When the risk premium in the US stock market fell far below its historic level, Shiller (2000) attributed this 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 stabilizing power of Mr. Greenspan. We would like to thank seminar participants at the Bank of England, Bank of Finland, the Warwick Financial Options Research Centre and the University of Iowa for comments and suggestions, particularly John Campbell, Daniel Cohen and Stewart Hodges. While working on this paper, Marcus Miller was Visiting Scholar at the IMF Research Department and he is grateful for their hospitality, but the views expressed are those of the authors, and do not necessarily represent those of the IMF. We are grateful to the ESRC for its financial support under project R000239216 Moral Hazard and Financial Institutions. JEL Classification: G12, E52, D84.