Asset Price Bubbles and Banking Crises - Japan 1990 and US 2007

1. What is an asset price bubble and why do they matter?

Asset price bubbles are not a new phenomenon. Defined as an upward price movement over a period of time which is unexplainable based on fundamentals, and which subsequently implodes (Siegel, 2003), asset price bubbles have plagued financial systems throughout history. Indeed, some of the first occurrences of economic bubbles date back to the 17th and 18th century; tulipmania in 1634-1638 Holland saw the price of tulip bulbs explode almost 60-fold only to abruptly crash. Historic causes for such “mania” include speculation, market manipulation and human psychology (Siegel, 2003). Financial bubbles matter as their implosion can be associated with a substantial loss of income, large institution failures, socio-economic distress, as well as more recently, systemic risks.

Over the past 40 years, asset price bubbles have been a catalyst to particularly destructive banking crises. Interestingly enough, they have recently been fueled by new more modern causes:

1)Globalization and the resulting capital flow bonanzas (and collapses) have led to exchange

rate crises in certain emerging markets: Mexico 1994, East Asia 1997, and Argentina 2001.

2)The new international financial architecture of increased liberalization, deregulation and

innovation, had a large role to play in the U.S. 2001 dot-com bust and subsequent recession.

3)Policy mistakes, excessively loose monetary policy in particular, has in many instances

exacerbated asset price movements.

This memo will concentrate on a particularly pernicious breed of economic bubbles: real estate bubbles (Rogoff & Allen, 2011). This memo will analyse two generations of housing price spirals: the Japanese 1990 bust and Lost Decades, as well as the 2007 U.S. subprime mortgage collapse and financial crisis. It will conclude by arguing that the “Greenspan principle” or non-intervention in bubbles is outdated and that policy-makers should actively seek to prevent future episodes.

2. Japan: From Asian Miracle to the Lost Decade(s)

From 1960 until 1990, post-war Japan was the world’s fastest growing economy. At an average annual GDP growth rate of 6.10%, the record expansion was even coined the “Asian Miracle”, but the miracle unfortunately turned sour. From 1990 to 2010, growth slowed dramatically and only averaged 0.97% annually, inflation turned negative and public debt increased exponentially; the period was eventually termed the Lost Decades (Figure 1). In 1990, nine of the world’s top ten banks in asset size were Japanese, but a mere decade later, two large banks had collapsed and none remained ranked among the world’s top ten (Hugh, 1998). Even in 2012, Japan remains paralyzed in a state of stagflation and excessive public debt. What happened?

Source: IMF

Many scholars agree that Japan’s Lost Decades are due to a banking crisis caused by bubbles, particularly in real estate. During the pre-1990 boom, banks extended a large amount of loans, often using land as collateral due to the widespread postwar belief that land prices would never decline. Strong growth, as well as bubbles in both real estate and equity markets raised bank capital and allowed for such activity to continue. However, in 1990, when land prices dropped dramatically (figure 2) and when the Nikkei 225 crumbled almost 75% (figure 3), banks suffered from a large increase in non-performing loans relative to capitalization and reserves. From 1992 to 1998, Japan’s 21 Big Banks wrote off ￥42.02 trillion of bad loans, a huge number when compared to the banks’ peak amount of capital of ￥22.15 trillion in 1994 (Hugh, 1998). The banking crisis led to a credit crunch, and through depressed investment, spread to the real economy.

2.1. Causes of the Stock and Real Estate Bubbles

At its peak, the land around the Imperial Palace in Tokyo was reputed to be worth more than the entire state of California (Kawai, 2005). What caused such a substantial equity and real estate bubble? Three main causes linked to Japa n’s financial architecture are identified below.

1)Banking deregulation and liberalization: Japanese banking underwent gradual structural reform in

the 1970s. The old postwar system, based on interest rate controls and mandated wide spreads between deposit and loan rates, essentially guaranteed profit to all financial institutions (Hugh, 1998). The system was very stable and there was little inter-bank competition. In the 1970s however, Japan shifted to an economy in which savings exceeded investment, and pressures for a financial system based on competitive banks and market-based interest rates became irresistible (Hugh, 1998). The process of deregulation took place without an adequate supervisory body, and the Ministry of Finance failed to apply proper capital controls on banks. The new competitive environment increased both risks and opportunities; banks began diversifying into profitable but risky investments in small and mid-sized companies and in real estate. Mortgage limits rose from 65% of home value on average to 100% and between 1983 and 1989, and Japanese banks doubled their lending to firms involved in the real estate sector from 6% of total lending to 12% (Posen, 2001). Deregulation thus created the necessary conditions for a boom in equity and land prices.

2)Financial innovation and speculation: The equity and real estate bubble was fueled by an increase

in speculation enabled by financial innovation, which regulation could not keep up with. The 1970s and 1980s saw a proliferation of new investment vehicles such as complex derivatives and sophisticated trading technologies, which increased the breadth and depth of financial activities

(Hugh, 1998). Japan, in particular, underwent a wave of financial engineering, called zaitech, during the period, which increased demand for speculative investment. As exports dropped due to an appreciating Yen relative to the USD, banks and corporations turned to speculation to boost profits. Toyota Mortors in 1986, for instance, relied upon zaitech speculation for one-third of its pre-tax, and it is estimated that Nomura Securities devoted $142 billion of its $237 billion worth of assets under management to zaitech; given these figures, doubts about an impending market crash were already mounting as of 1987 (Engdahl, 1987). Excessive zaitech increased volatility in Japanese financial markets and is therefore partly responsible for the speculative boom and subsequent bust in equity prices.

3)Prolonged monetary easing: Cheap credit and high liquidity in the financial system also fueled the

run up in equity and land prices. In 1986, the Bank of Japan responded to a short-term economic slowdown resulting from Yen appreciation by monetary stimulus; money supply expanded and interest rates were reduced to postwar lows (figure 3). The policy was successful in stimulating growth, but was also responsible for strong increases in consumption, investment and risk-taking, directly fueling an asset price bubble. The policy was only reversed in 1989, but many critics argue that monetary easing lasted too long and that the subsequent sharp rise in interest rates punctured the bubble, leading to crisis and stagnation (Hugh, 1998;Hoshi & Kashyap, 2004).

2.3. Japanese Government Response

The effects of the 1990 banking crisis are still being felt today, as Japan is stuck in a state of stagflation. Why has the crisis endured for so long? Policy mistakes are not only credited for partially causing the 1986-1990 asset price boom, but also for allowing the crisis to endure after the bust. Critics argue that the government response not only lacked commitment, but was simply too little, too late (Hugh, 1998;Hoshi & Kashyap, 2004). In terms of monetary policy, the Bank of Japan took five years to reduce interest rates to the 0% nominal bound (figure 4), and in terms of fiscal policy, government account balances only turned significantly negative as of 1995 (figure 5). This data demonstrates that Japanese policy makers underestimated the extent of the 1990 bust and ensuing banking crisis. Consequently, the immediate response was slow and not nearly aggressive enough. In terms of the long-term response, the government decided to provide subsidies to banks, that would otherwise fail, and by pushing them to extend credit to firms despite limited prospects of repayment. Japanese banks are today both dependent and paralysed by these subsidies, coining the term “zombie banks” (Hoshi & Kashyap, 2004).

Source: Bank of Japan; IMF

3. U.S. 2007 Real Estate Bust and Banking Crisis

The U.S. was on a steady growth path for much of the 2000s, but the outlook changed in 2007. The mortgage market, which had been rapidly rising, rolled over (figure 6), putting pressure on heavily exposed banks’ balance sheets. A banking crisis ensued in w hich Bear Stearns and Merrill Lynch were respectively absorbed by J.P. Morgan and BofA, finally culminating on September 15th with the failure of Lehman Brothers. Equities tumbled (figure 7) and the resulting drop in aggregate demand sent the U.S. into recession (figure 8). Through globalization, the crisis was transmitted to other countries and is a prime cause of the ongoing Euro debt crisis. What went wrong?

Real GDP Growth Unemployment rate

Source: Standard and Poors; IMF

Source: Standard and Poors; IMF

The main causes of the 2003-2007 real estate boom are related to the U.S. financial architecture. The U.S. story is stingingly similar to the Japanese story, as illustrated below:

1)Banking deregulation and liberalization: Under Fed chairmanship of Alan Greenspan, U.S. banking

underwent structural reform. Indeed, the 1984 savings and loans crisis led to a move towards a securitisation-based mortgage sector, between 1987 and 1996, the Fed eased restrictions on banks going into the securities business, and in 1993, passed legislation exempting financial derivatives from regulation (Suarez & Kolodny, 2010) . The liberalization process culminated in 1999 with the Gramm-Leach-Bliley Act, which repealed the Glass-Steagall Act of 1933, essentially allowing the merger of banking, securities and insurance companies. Banks could now diversify into risky sales and trading activities, as well as issue complex subprime mortgage derivatives with little regulatory supervision, all while increasing leverage. U.S. banking liberalization thus played a crucial role in the housing boom; it created a financial environment in which bubbles were possible.

2)Financial innovation and speculation: The U.S. real estate market underwent significant change in

the 2000s. From a traditional origination-hold model, the market moved towards an origination-

securitization model (Wyplosz, 2012), and this was largely motivated by the development of new financial products. Financial derivatives such as collaterized debt obligations (CDOs) and mortgage-backed securities (MBS) allowed for lenders to package mortgages and sell them off to various investments bank and investors. Furthermore, based on the belief that home prices would continue to rise, mortgages were even offered to “subprime” lenders such as NINJAS, or individuals with no income, no job and no assets. Through innovation and a complex tranching process, these “subprime” loans were packaged together and often given a AAA rating under the assumption that there was little correlation between individual default risks. Financial innovation thus led to a boom in investment and mortgages origination, fueling the bubble in housing prices. Unfortunately, subprime defaults turned out to be correlated, and when house prices peaked in 2006, defaults increased exponentially (figure 9). Banks were heavily exposed to the mortgage market and their balance sheets began to suffer culminating in a full-blown banking crisis in 2008.

3) Monetary Easing : In response to fears of economic slowdown after the 2001 dot-com bust, the U.S. Fed significantly dropped interest rates (Figure 10). Monetary easing continued until 2005, but the low interest rates had already fueled an investment boom. In this sense, the housing bubble was facilitated by high liquidity and access to cheap credit, courtesy of the U.S. Fed. g

3.2. U.S. Government Response The U.S. government initiated a quick and extremely strong response to the 2008 banking crisis. Interests rates were quickly reduced to the 0% bound, and the government increased spending through bailouts and the Troubled Asset Relief Program (TARP) (Figure 11a). In 2009, due to slow economic recovery, the Fed began quantitative easing, further providing liquidity to financial systems and depressing government bond yields despite large increased in public debt (figure 11b). Source: Wyplosz 2012; Fed Reserve Source: IMF Source: Wyplosz; US Federal Reserve Figure 9: Loan Delinquency Rate (%) 200020052010

-4%

-2%

0%

2001

20032005200720092011Figure 11a: U.S. Fiscal Balance (% of GDP)

4. Policy Recommendations and Conclusions

The first main conclusion from the analysis of the Japanese and U.S. episodes is that they are both very similar. They both show that bubbles, particularly in real estate, can pose a serious threat to the economy. Banking crises often result from excessive investment booms, and governments should thus monitor whether asset prices are exaggerated relative to fundamentals. Given this threat, the “Greenspan principle” that government policy should not try to prevent bubbles but only fix the mess afterwards (Reinhart & Rogoff, 2009), seems rather outdated. Instead, government officials need to act both to prevent asset price bubbles ex-ante, as well as contain them ex-post.

4.1. Preventing Future Asset Price Bubbles

A striking feature of the Japanese and U.S. episodes is that they were both caused by similar factors. Indeed, the financial architecture (deregulation, liberalization, innovation) and monetary easing lead in both cases to large price swings. Measures need to be undertaken to compensate:

1)Regulation and liberalization: New international and domestic regulation has started to develop

after 2008 with the development of the Financial Stability Board, Basel III and the Dodd-Frank Act in the U.S. Much of this new regulation seeks to reduce the risk banks can undertake through, for instance, stricter capital requirements of a ban on proprietary trading. By limiting banks, these new restrictions will reduce the odds of creating bubbles, as well as reduce bank exposure to their potential collapse. Hence, such regulatory activities need to be continued and strengthened1)

2)Keep up with innovation: While financial innovation is not bad per se, regulation has largely failed

to keep up. Efforts to improve financial efficiency through technological improvements need to continue, but regulatory bodies also need keep up. Complex derivatives, by enabling large-scale trade in real estate, had a large role to play in both the Japanese and U.S. bubbles, and as such, regulators need to both understand the new financial products being issued and act to reduce potential systemic risks. Rogoff & Allen (2010) propose certain macro prudential policies that would reduce trade in real estate, such as tax increases or direct restrictions on real estate lending.

3)Conservative monetary policy: Central banks, by lowering interest rates, had a large role to play in

the Japanese and U.S. bubbles. The traditional central bank role of inflation targeting has been unable to prevent the formation housing bubbles. There is thus a strong case for central banks to begin monitoring real estate prices and avoid low interest rates altogether.

4.2. Response and Containment of Future Asset Price Bubbles

By comparing the two housing episodes, it seems U.S. policymakers were better able to contain the consequences of the bursting housing bubble. While still in a low-growth environments, it doesn’t look like the U.S. will follow in the footsteps of Japan and its Lost Decades. Why?

1) Quick and aggressive response: Unlike Japanese policy-makers, the U.S. government did not

underestimate the spillovers from the housing bubble. The fiscal and monetary reaction was immediate and very strong; even when interest hits the their 0% bound, it only took the U.S.

roughly a year to attempt aggressive quantitative easing, whereas it took Japan roughly 10 years.

While the U.S. reaction could not prevent a deep recession, it has most certainly aided the economic recovery.

2) Prevent bank failures: In both cases, a number of banks were on the brink of failure. The spillover

from the collapse of Lehman Brothers seems to suggest that these financial institutions are indeed “too big to fail”. Whereas Japan decided to subsidize their banks in order to keep them alive, the U.S. government pushed for intra-bank mergers and takeovers. The U.S. reaction seems to have been more successful than the Japanese one; while Japan still suffers from numerous “zombie banks”, U.S. have returned to profitability and are still amongst the largest in the world.

4.3. Difficulties to Overcome

Dealing with financial bubbles is not an easy task. First, while it is easy to establish the existence of a bubble ex-post, it is extremely difficult to do so ex-ante. Even specialised analysts disagree on whether there is currently a housing bubble in China for instance; some believe the boom is due to fundamentals such as large increases in income, whereas others believe it is wild speculation. A second challenge is to overcome the “this time is different syndrome” (Reinhar t & Rogoff, 2010). Rather than try to justify price increases, it is preferable for policy-makers, given the large threat posed by bubbles, to err on the side of caution and adopt conservative measures. Finally, no policy-maker, for both electoral and personal reasons, wants to be perceived as “the guy preventing growth” or “the guy who popped the bubble”. Given thes e reputational difficulties, it is crucial for central banks to remain independent of elected government, and to officially be given the mandate to monitor and prevent future asset price bubbles.

Works Cited

Engdahl, William. "Will Japan's "zaitech" Bring a Market Crash?" EIR 14.38 (1987).

Hoshi, Takeo, and Anil K. Kashyap. "Japan's Financial Crisis and Economic Stagnation." Journal of Economic Perspectives 18.1 (2004): 3-26.

Hugh, Patrick. "The Causes of Japan's Financial Crisis." Conference on Financial Reform in Japan and Australia (1998).

Kawai, Masahiro. "Reform of the Japanese Banking System." Institute of Social Science, University of Tokyo (2005).

Posen, Adam S. "Did Monetary Laxity in Japan Cause the Bubble?" CESifo (2003).

Reinhart, Carmen M., and Kenneth S. Rogoff. "Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison." National Bureau of Economic Research (2008).

Rogoff, Kenneth, and Franklin Allen. "Asset Prices, Financial Stability and Monetary Policy." Swedish Riksbank Workshop on Housing Markets, Monetary Policy and Financial Stability (2010).

Siegel, Jeremy J. "What Is An Asset Price Bubble? An Operational Definition." European Financial Management 9.1 (2003): 11-24.

Suarez, Sandra, and Robin Kolodny. "Paving the Road to "Too Big to Fail": Business Interests and the Politics of Financial Deregulation in the U.S." Temple University: Politics & Society (2010).

Wyplosz, Charles. "The U.S. Mortgage Market Crisis." Political Economy of the Crisis Lecture 3. Voie-Creuse Building, Geneva. 6 Mar. 2012. Lecture.