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September 21, 2004

Asset Price Bubbles - What Have We Learned?

Toyoo GYOHTEN (President, Institute for International Monetary Affairs)

It is certainly not easy to identify clearly causes of a bubble. There are naturally various factors which contributed to the creation of a bubble, and each factor has its own background. Therefore, what we can do at the best is to trace the mainstream of the event exploring the dynamics of the undercurrent. When we study the experience of a bubble, our first task is to understand why and how the bubble was created. It is equally important to review how we have dealt with the aftermath of the bubble.

In my brief presentation about the Japanese experience of bubble, I will focus on the first part because there are already hundreds of books written to tell us how poorly we handled the post-bubble situation and also, to be exact, the chapter is not closed yet.

I believe there will be no objection to the view that the Japanese bubble in the late 80's was nurtured primarily by the rapid expansion of liquidity in the economy. Between January 86 and February 87 the Bank of Japan cut its discount rate five times from 5.00 to 2.50. Bank lendings grew by more than 10% each year. The bank loans financed investments in assets such as land, condominium, stocks, etc. The price of land in Tokyo more than doubled between 86 and 87 and the NIKKEI average did the same.

Three questions come up quickly. Why investors continued to pour in money to properties? Why banks continued to lend to investors? Why the Bank of Japan continued to maintain easy money policy?

Although it is difficult to provide sensible answers to these questions now, they were the easiest questions to answer in 87. The economy was booming. GDP was growing at 5-6%. The only item Japan could not produce more was the land. When people believed in an everlasting growth of the economy, the price of land, the supply of which was absolutely limited, was bound to rise. The purchase of property was the safest form of investment. For banks the lending which was secured by property as collateral was the easiest way of doing business. As the market value of collateral kept going up banks could expand their loan assets with virtually no credit risk. The Bank of Japan was indeed growingly uneasy about the soaring property price. However, they were under political pressure to maintain easy monetary policy. There was international pressure, led by the US, urging Japan to reduce its large trade surplus by stimulating domestic demand. Since the government and the ruling political party were in favor of the fiscal consolidation there was a strong alliance between them to ask the Bank of Japan to carry out the job by expansionary monetary policy. The independence of the central bank at that time was not established strongly enough. It was also true that the Bank of Japan was reluctant to accelerate the strengthening of the yen by raising the interest rate. Furthermore, the collapse of the stock market in October 87, so-called Black Monday, intimidated the Bank of Japan.

Aside from these factors, the most intriguing was the fact that the Bank of Japan was apparently not of the view that the asset price bubble was a serious danger which the central bank had to deal with by all means. There seem to be two explanations to this strange perception. First, all of the traditional measurements of price development such as consumer price, wholesale price and producer price were almost flat or even declining. In other words there was no inflation in conventional terminology. Second, it cannot be denied that even the Bank of Japan was a victim of the euphoria that when there is an ever growing demand against a fixed supply the increase of price is more than natural. The greatly increased vulnerability of the balance sheet of banks, corporations and household was not perceived as an imminent danger for the economy.

Thus, the asset price bubble continued until 89 when the Bank of Japan was finally alarmed by the start of a strong increase of traditional price indices. The Bank of Japan raised its discount rate rapidly and the government imposed strict control over the bank lending to property investment. The bubble burst and the devastating deterioration of balance sheet was materialized thus marking the onset of a more than ten years stagnation.

While there are many lessons we have learnt from the episode which cost us so much, I think following four are the most important ones.

First, we misjudged the relative degree of seriousness among various risks. Indeed, there were several risks in the economy in 86-87. The rapid appreciation of the yen was thought to be threatening the nascent recovery of the economy. The incessant American criticism against Japan's large trade surplus was a source of political concern. Fiscal deterioration was progressing. The bubbly frenzy in the property market was making the increasing number of people uneasy. In hindsight the most serious risk was the dangerous deterioration of the bloated balance sheet of the economy. However, there was no clear understanding of the situation. No policy maker was competent enough to establish a clear view about the landscape of the economy and identify the implication of various risks.

Second, as the result of the inability to have a clear and accurate picture of the economy we made a mistake in the selection of the primary aim of economic policy. Among various risks we perceived in the economy, the concern about the exchange rate has somehow overshadowed others. There were certain reasons for the concern. Indeed the appreciation of the yen vis-à-vis the dollar was very rapid. During the two year period between February 85 and February 87 the yen appreciated by more than 40% from \264 to \154. Export industries suffered and their grievance was echoed by politicians who asked the government to take measures to stem the appreciation. The government took two steps. One was to intervene in the exchange market and the other was to pursue expansionary monetary policy in order to stimulate domestic demand and increase import thereby ameliorating the international pressure to strengthen the yen. In retrospect it was a wrong choice to put the exchange rate as the main objective of economic policy. Instead we should have focused our attention to the structural reform of the economy. We should have stepped up the deregulation in the protected industries such as services, distribution, construction, and agriculture. Liberalization in these industries could have increased imports and reduced the gap between international price and domestic price which was a major cause of the antipathy against the strong yen.

Third, our choice of the policy instrument was wrong. In our effort to stimulate the domestic demand we relied too heavily on monetary policy as if there were no other policy instruments. The utilization of fiscal stimulus and pro-growth micro-economic policy was never seriously considered or, when there was suggestion to that effect, it was rejected. The reason of such obstinacy was rather crude. The Ministry of Finance which was obsessed with the idea of fiscal soundness stubbornly refused to be dragged into fiscal expansion. The ministry was concerned about the deteriorating fiscal situation and was determined to protect its own turf. The ministry has skillfully persuaded the mainstream politicians to support its position. In hindsight there were variety of ways through which fiscal policy could be used to stimulate domestic demand. Obviously selective tax reduction was one. Also, the government could shift fiscal resources to sectors where the demand elasticity was high from inefficient sectors such as public works and agricultural support. Also, structural reform policies such as deregulation and privatization must have been useful and necessary. However, there was no political leadership strong enough to override the resistance of vested interest groups in bureaucracy and private business who had strong alliance among politicians. In the end, the combination of these factors was bound to force the monetary policy to carry the full burden.

Fourth, the timing of policy implementation was either too slow or too quick. The reversal of the monetary policy in May 89 was clearly belated. The recovery of the economy was already evident as early as spring of 87, and by 88 the bubble of property price was fully blown. Nevertheless, the Bank of Japan hesitated and missed the opportunities. Later, central bankers tried to excuse themselves for their mistakes while blaming undue political pressure. The crime was committed, however. To make the situation worse, the Bank of Japan, when it reversed the policy, tightened the monetary policy too much and too quickly. It raised its discount rate five times in 15 months from 2.5% to 6.0%. It did such a machine-gun style tightening without careful assessment of the impact of such action. The Bank of Japan was simply obsessed by the desire to kill the bubble with no idea how such hard landing would create a devastating situation in the economy. Also, the heavy-handed jawboning on the bank lending disrupted the market excessively and unnecessarily.

All in all, we could not prevent the birth of bubble because we could not distinguish the real risk in the economy, because we set a wrong target for economic policy, because we chose wrong policy instrument, and because the timing of our policy implementation was wrong.

All said, the last question is why all these mistakes had to be made? Here I have to touch upon the issue of the structure of policy making in the country. In summary we lacked a system in which different views, interest and position of various stakeholders in the policy making process are sorted, analyzed, coordinated and put into the formulation of the final decision. The Bank of Japan was not strong enough. Its relation with the government was always tainted with a sense of mutual mistrust. The Ministry of Finance was always obsessed with the arrogance of fiscal autonomy. Influential politicians representing various vested interest groups exercised unconstitutional power over the government. The government, led by the Prime Minister, did not demonstrate the strong leadership as executive branch. Rather its effort was directed to fabricate a compromise without firm principle. The media was mostly populistic and opportunistic without enlightened foresight and conviction.

These defects are all too well known now, and it is indeed welcoming that significant improvement was achieved in recent years. In that sense the lessons were well learnt. Nevertheless, I have to confess that the price of the lesson was exorbitant.

(Full text of the speech presented on August 19, 2004 in Aspen)

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