A principle that, according to U.S. Federal Reserve Board chairman Alan Greenspan, defined much of the world economy in the 1980s and 1990s.
On Dec. 5, 1996, Greenspan gave a speech in Washington, D.C. purportedly about Japan, in which he asked: "How do we know when irrational exuberance has unduly inflated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the last decade?"
What it means
High finance is a gamble, mostly based on the idea that you, the investor, have a better idea than the other guy how a given investment is going to pay off in the next little while.
If a lot of people think an investment is going to pay off big, they buy into it and drive up the price for future investors. If you buy in, it means you think it's going to do even better than its current price indicates other people think it will. (You can also bet against an investment by selling short, but the concept there tends to make otherwise intelligent people's minds break, so we won't go into that.)
One way of judging a stock, in particular, is by its "price-earnings ratio," which compares the price of the stock to how much money the company in question is actually making right now. The higher the ratio, the more spectacular investors expect its growth to get.
OK. If investors get irrationally exuberant, that means they're wildly optimistic about how their investments are going to do. They buy stocks (and other investments) without regard for evidence about their past performance or how well they're likely to perform in the future. They buy on faith. Stock prices soar, reinforcing the idea that everything's going just great and is going to get even better.
If things get really out of control, they start borrowing money to invest it. They sink money into just about anything with an "Inc." in its name. They make really, really bad investments.
Eventually, investors realize that the companies they've bought into aren't actually pulling off the miracles they expected. Prices fall. Investors pull their money out. Their investments lose value on paper, so investors feel like they have less money, so they spend less. The "real" economy, the kind that's based on actually making stuff and selling it and using it up and buying more, starts to shrink. Companies go bankrupt. People lose their jobs. If they invested irrationally, they can't pay their debts and go personally bankrupt.
What Greenspan was warning about
Although the long boom had been going on since the '80s (with a hiccup in the early 1990s that didn't last very long), in 1996 the high-tech hyperboom was really getting going. The boom was based in the United States, but extended into most of the developed world. It was based on smoke: price-earnings ratios were through the roof, with companies with no products pulling off billion-dollar initial public offerings, because investors believed. Greenspan saw that they were believing in mirages and tried to warn people, subtly, without panicking them.
It didn't work.