Two Generations of Asset Price Bubbles: From 1990 Japan to 2007 U.S.

Eric Rashi

What are Asset Price Bubbles?

0 An upward price movement over a period of time, unexplainable based on fundamentals, and which eventually implodes

0 Implosion associated to widespread socio-economic distress

0 Not a new phenomenon:

0 Irrationality: mania

0 Human psychology

0 Market manipulation

New More Modern Causes

Globalization

New Financial Architecture

Policy Mistakes

1

2

3

The Current Problem

0 “Greenspan” principle: policy-makers should not intervene in the markets to prevent bubbles, only clean up the mess once they burst

BUT…

0 Bubbles are very dangerous: history of leading to banking crises

0Japan 1985-1990 “Lost Decades”

0U.S. 2003-2007 Global Financial Crisis

Japan: From Asian Miracle to “Lost Decades”

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

2012

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

Real GDP Growth Inflation

Japan Real Estate Bust…

0 1990 real estate bust put pressure on banks’ balance sheets

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

0

50

100

150

200

250

300

Nominal GDP Land Prices

Rebased: 1980 = 100

Coupled with Equities Bust

0 Full-blown banking crisis:0 1992-1998: 21 Big Banks write of ¥42.02 trillion of bad loans0 Peak capital base during time period was only ¥22.15 trillion in 1994

1980 1985 1990 1995 2000 2005 20100

10,000

20,000

30,000

40,000

Nikkei 225

Causes of Japan’s Financial Bubbles

• From controlled to competitive market-based system

Banking liberalization

• Financial engineering (zaitech) enabled speculation

Financial innovation

• Cheap credit and high liquidity

Prolonged monetary easing

Japanese Government Response

0Underestimated crisis: too little, too late:

0Long-term measure: provide subsidies to failing banks

1980 1985 1990 1995 2000 2005 20100%

2%

4%

6%

8%

10%

Central Bank Interest Rate

19901991

19921993

19941995

19961997

19981999

20002001

-8%

-6%

-4%

-2%

0%

2%

4%

Fiscal Balance (% of GDP)

2008 U.S. Crisis : Similar Story?

0

50

100

150

200

250

Nominal GDP

S&P Case-Shiller Home Price Index

Rebased:1995 = 100

2002 2004 2006 2008 2010 20120

400

800

1,200

1,600

S&P 500

Spread to Real Economy

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

Real GDP Growth Unemployment rate

0 Full-blown banking crisis: heavily exposed banks are acquired or collapse

Causes of U.S. Housing Bubble

• Greenspan led deregulation: Gramm-Leach-Bliley Act 1999

Banking liberalization

• Mortgage market securitisation: tranching, CDOs, MBS, …

Financial innovation

• Cheap credit and high liquidity after 2001 dot-com bust

Prolonged monetary easing

U.S. Government Response

0Immediate and aggressive

0Pushed for “private sector solution” amongst banks

1995 2000 2005 20100%

2%

4%

6%

8%

Fed Interest Rate

20012002

20032004

20052006

20072008

20092010

20112012

-8%

-6%

-4%

-2%

0%

Fiscal Balance (% of GDP)

Main Takeaways

1) The Japanese and U.S. episodes are strikingly similar

2) Bubbles, particularly in real estate, can pose a serious threat to the real economy

3) “Greenspan principle” seems outdated:

Policy-makers need to contain spillovers (ex-post)

Also need to act proactively (ex-ante)

Preventing Future Asset Price Bubbles

• Continue with efforts: Basel III and U.S. Dodd-Frank Act

Re-regulation

• Understand complex products and reduce systemic risks

Keep up with financial innovation

• Monitor real estate prices and avoid low interest rates

Conservative monetary policy

Response to Future Asset Price Bubbles

0 U.S. response was more successful in containing damage from housing collapse and in returning economy to growth:

0 Must act quickly and aggressively

0 Must protect banks

Difficulties to Overcome

0 Preventing and reacting to bubbles is not an easy task:

1) Bubbles are difficult to establish ex-ante2) Reputational difficulties for policy-makers

0 But… given the threat, these difficulties must be overcome...

Questions?

Bubbles: difficult to establish ex-ante

1998 2003 20080

100

200

300

400

Chinese Property Price-to-Earnings Ratio

National Average Property Price

Urban Household Disposable Income per Capita

Rebased to 1998 = 100

U.S. Loan Delinquency Rate (% of total)

U.S. Gross Public Debt (% of GDP)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20120%

20%

40%

60%

80%

100%

120%

Japan Public Debt (% of GDP)

19801982

19841986

19881990

19921994

19961998

20002002

20042006

20082010

20120%

50%

100%

150%

200%

250%