Keenan Viney
One of the most iconic asset price bubbles in recent history was experienced by Japan during the 1980s. Several factors contributed to the bubble, but the main focus of this paper will be the effects on real estate. During the bubble, the housing prices of Japan became disconnected from rental prices.
In this disequilibrium, all relevant information was not included in the price, as the efficient market hypothesis would suggest. Therefore, the prices of the housing market could only continue to rise until the bubble had reached its tipping point in 1991. As real estate prices started to soar, so did the Japanese stock market. The rise in the stock market was so significant that in two years the value of the Nikkei 225 doubled. The market continued to rise and at its peak the Tokyo Stock Exchange reached a value of $3.5 trillion in 1989, this was about a third more than the value of all of the firms listed in the New York Stock Exchange. As Clairmont (1993) describes it, people viewed the bubble as being “unstoppable”. When the bubble finally burst $8.5 trillion was wiped out and many of the Japanese banks that had become the largest banks in the world were decimated. This crash became known within Japan as the “Great Crash”.
The value of an asset is given by the present value of its income stream. The present value is determined by discounting successive returns by some market interest rate. So long as the interest is greater than the return growth rate, the asset price is bounded. But under certain conditions when the interest rate is less than the dividend growth rate the asset price may be rationally bid up infinitely. We do not live in a world of infinite asset prices so these conditions must not hold. However, for certain short periods the growth rate of asset returns exceeded any reasonable market interest rate.
This was the mechanism that drove the asset price bubble in Japan, it had two main causes. The first occurred at the end of the 1970’s when the Japanese government reformed financing laws for the large collective firms know as keiretsu. By allowing these firms to issue corporate bonds, Japanese major banks had an increased capacity for real estate loans. Nada Mora (2008) shows that for each 0.01 increase in the ratio of a prefecture’s real estate loans to total loans; real estate inflation increased by 14-20% over 1981-1991. Within the framework of perfect capital markets, a banks willingness to lend should not increase asset prices.
Mora (Ibid) highlights the importance of credit constraints in the Japanese real estate bubble and makes the case that casual investors may not have recognized the importance of corporate financing deregulation in driving asset prices. The other cause of asset price inflation is related to real estate’s unique productive capacity. Land prices will increase as the productivity of the land increases. The land price increase then increases the net worth of the firm that owns the land. This allows the firm to borrow more money and further increase the productivity of land and price of real estate. When this mechanism is active the demand for land increase in its price. Information about the loan supply and productivity shock mechanisms was not incorporated into prices. This means the market was not fully efficient in an information sense and this prevented investors from making unbiased rational decisions.
The rise in Japanese real estate prices were driven by credit and at the high point of this asset bubble, the Tokyo Imperial Palace land was worth the same amount as all the land in California (Malkiel, 2000). These prices were disconnected from any fundamental and the inevitable price collapse happen in early 1990. Malkeil suggests that the bubble was pricked by an interest rate increase by the Bank of Japan (Ibid). What followed has been described as Japan’s lost decade; with stagnant growth and ineffectual monetary policy (Krugman, 2000).
Given the social cost that this bubble had on Japan and if the central bank was indeed the cause of the collapse, wouldn’t it have been better for the central bank to act sooner? First, let us consider whether or not the Bank of Japan could have caused the price correction. Mishkin and Serletis (2011) suggest there are two types of asset bubbles, one fuelled by credit and the other the result of, what Alan Greenspan termed, irrational exuberance. We have argued that credit did play a role in increasing real estate prices as the result of financial deregulation. Although overly optimistic investors play a role as well, if credit fuelled the Japanese bubble then the Bank of Japan could have raised interest rates to make credit more expensive. This would only work under two conditions. If the rate of return was sufficiently high, a modest increase in the interest rate would not be enough to decrease real estate prices[1].
Another necessary condition for the central bank effectiveness is that the overvalued assets must make up a large enough portion of the total assets in the economy. Since one or both of these conditions were violated, it seems more likely that the precipitous fall in prices may have been due in part to other factors. Moving forward, what we can central banks learn from the Japanese real estate bubble? Generally, it is difficult to predict which assets are overvalued and central banks are hesitant to make interventions that directly focus on asset markets rather targeting the inflation rate.
The Bank of Japan was able to realize the overvaluation of real estate simply due to the magnitude of the bubble. The raising of interest rates likely coincided with a negative productivity shock, which sent real estate prices into freefall. The situation that the Bank of Japan found itself in could have been best addressed with macro-prudential regulation. When a central bank sees a credit fuelled bubble emerging it should enact regulation that limits credit to an over-valued asset (Mishkin & Serletis, 2011). The Bank of Japan, in concert with the central government, could have imposed high collateral requirements for lending for real estate and this would have deflated the bubble sooner. It is important for central banks to use regulation to prevent bubbles from effecting the real economy and to achieve their mandate of minimizing social loss
[1] As previously stated, when the rate of return is growing at a rate greater than the interest rate, the asset price will increase indefinitely.
References
Clairmont, F. (1993) Cracking of Japanese Finance Capitalism. Economic and Political Weekly,
Krugman, P. (2000). Thinking about the liquidity trap. Journal of the Japanese and International Economies, 17, 221-237.
Mora, N. (2008) The Effect of Bank Credit on Asset Prices: Evidence from the Japanese Real
Estate Boom during the 1980s. Ohio State University
Malkiel, B. (1999). A random walk down wall street. (7 ed.). New York, NY: W.W. Norton &
Company.
Mishkin, F. & Serletis, A. 2011. <The Economics of money, banking, and financial markets
(4ed). Toronto, ON: Pearson Canada.
Manchester, J. (1989) The baby boom, housing and loanable funds. Canadian Journal of Economics.
Pratt, G. (1986) Housing Tenure and Social Cleavages in Urban Canada. Annals of the
Association of American Geographers
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