Irrational exuberance.

Those words, uttered with purposeful intent by Alan Greenspan on Thursday last week, sparked feverish sell-offs in stock markets around the world. Tokyo, Hong Kong, London, Frankfurt all fell resoundingly. And when the New York markets opened on Friday, the Dow Jones Industrial Average plummeted 145 points in the first thirty minutes of trading.

What happened?

Alan Greenspan, the Chairman of the Federal Reserve, makes a virtue of concealing his thoughts in elaborately-constructed sentences. Indeed he is known to have professed dismay when one of his public utterances turned out to be uncharacteristically lucid.

On this occasion, however, there was no mistaking his intention. In his Thursday speech, Greenspan suggested that the meteoric rise of the U.S. stock market in recent months may not have been entirely justified by economic fundamentals. An element of irrational exuberance may also have played an unhealthy role; the attendant speculative fervor, Greenspan feared, would have resulted in overvalued stock prices.

An overvalued stock market is a dangerous thing. At the first hint of bad news - a sharp spike in oil prices, lower-than-expected corporate profits - the bubble is likely to burst causing stock prices to tumble precipitously.

Greenspan wants to prevent such a meltdown in the stock market. His recent speech was a warning shot across the bow. By reminding the markets that he could resort to sterner measures, Greenspan hopes to curb egregious speculative activities in the stock market.

What are the sterner measures that made the markets quake in dread?

Simply put, an increase in interest rates.

As the Fed Chairman, Alan Greenspan presides over the conduct of monetary policy in the United States. This involves altering interest rates as needed in order to satisfy the primary responsibility of the Fed, viz. to ensure that inflation remains in check. Even his most ardent critics must concede that he has been enormously successful at this task. Despite years of low unemployment in the U.S. economy, a situation that ordinarily serves as the breeding ground for inflationary pressures, inflation has remained subdued. Of course, other factors have helped too - productivity gains, foreign competition, and (till recently) low oil prices - but the course steered by the Fed has been indubitably important.

If inflation is quiescent (another of Greenspan's words), why the thinly-veiled threat of higher interest rates?

Two reasons. First, though inflation has been dormant till now, any spurts in economic growth could change all that. To temper the pace of economic growth, the Fed may choose to raise rates.

Secondly, and this is what the speech really hinted at, the Fed may raise rates in order to "prick" the speculative bubble in the stock market. Such an action itself would lead to a decline in stock prices as rising interest rates would curtail economic growth and corporate profits. However, this decline may prove to be far preferable to what might happen if the stock market continued to charge ahead unchecked: a calamitous collapse later with dire consequences for the economy for years to come.

This is not idle fear-mongering. Look at the Japanese experience. Fuelled by loose monetary policy, the Japanese stock market climbed to dizzying heights in the 1980s. At the beginning of this decade, however, the party came to an end. The bubble burst, and the Tokyo stock market lost over 50 percent of its value. For the next six years, the Nikkei average has struggled to regain lost ground, but without much success.

To make matters worse, the collapse of stock prices was accompanied by a protracted recession in the Japanese economy. Even today, Japan continues to struggle with a sluggish economy and unemployment levels not seen in the last four decades in that country.

Greenspan would like to avoid such a denouement at all costs. In order to squelch undesirable speculation in the U.S. stock market, Greenspan may yet be forced to raise interest rates. By speaking his mind (in lucid fashion) now, he hopes that he will not need to do it. The stock market, and the economy, may owe Greenspan a debt of gratitude.