The Role of a Central Bank in a Bubble Economy - Section II

February 15, 1998

I. The Bubble Economy in Japan

This section describes the origins, efflorescence, and destruction of the bubble economy in Japan. The reader may find it helpful to refer to the charts below, which shows exchange rates, interest rates, and stock index figures for the period 1989-midyear 1993, and money supply, land prices, and wholesale and consumer prices for the period 1975-1994.

A. Origins: 1985-87

The origin of the bubble economy can be traced to the G-5 Plaza Accord of September, 1985, an agreement designed, among other things, to coordinate economic policy in the major industrialized nations and to counteract protectionist forces. As part of the Plaza Accord, Japan agreed to stimulate its economy in order to enhance domestic demand for U.S. products. The signatories also pledged privately to intervene in foreign exchange markets to drive down a U.S. dollar widely perceived as overvalued. The Plaza Accord initiated a process of international consultation that also generated the Baker-Miyazawa agreement of October, 1986, in which Japan agreed to implement specific stimulative measures, and the Louvre Accord of February, 1987, in which Japan agreed to "follow monetary and fiscal policies which will help to expand domestic demand and thereby contribute to reducing the external surplus." In partial fulfillment of these commitments, Japan adopted fiscal stimulation measures in 1985 and 1986.

The Plaza Accord did not take monetary policy directly into account, and, indeed, the spirit of the Accord did not translate obviously into any particular monetary policy. For example, a decrease in Japanese interest rates might be considered consistent with the Accord, since it would tend to stimulate the Japanese economy and thereby increase demand for American goods. On the other hand, a decrease in Japanese rates would also tend to strengthen the dollar against the yen, in contravention to the spirit of the Accord (a reduction in Japanese rates would make dollars more attractive to foreign investors). The effects of interest rate policy were ambiguous.

In the end, the Plaza process resulted in a decision to decrease Japanese rates, largely because the other G-5 countries were anxious to lower their own rates, and also because the BOJ wanted to counteract the downturn in the Japanese economy that followed the yen's appreciation against the dollar. Both the Baker-Miyazawa agreement and the Louvre Accord contained specific Japanese commitments to lower interest rates. The BOJ reduced the official discount rate five times between January, 1986 and February, 1987, leaving it finally at 2.5 percent.

B. The Bubble Economy: 1987-89

Between 1987 and 1989, the BOJ conducted a lenient monetary policy, partly to comply with its promises in the Plaza and Louvre agreements, partly to offset the deflationary impact of a rising yen (the yen rose against the dollar from 251 at year-end 1984 to 122 at year-end 1987). The discount rate of 2.5 percent adopted in February, 1987 remained in effect until May, 1989. The money supply was growing at over 10 percent a year, much faster than GDP which grew between 4.8 and 5.9 percent between 1987 and 1989. Market interest rates were low. Nevertheless, inflation appeared to be virtually nil; the consumer price index rose only .4 percent in 1987, 1 percent in 1988, and 2.7 percent in 1989. Despite a moderately strong yen, Japanese exports and trade surplus with the United States continued to grow.

The Japanese stock market responded with a massive rally, accelerating a trend that had been ongoing since 1984. Starting at about 20,000 at the beginning of 1987, the Nikkei 225 rose quickly through much of the year. The rally was interrupted by the worldwide share price collapse of October, 1987, but by the Spring of 1988 the market had recovered and was surging to new highs. In 1988 the Nikkei 225 set new records and rose 39.9 percent in local currency terms, closing at over 30,000. By the beginning of 1989, Japanese share markets accounted for more than 42 percent of the value of all markets worldwide, up from 15 percent in 1980.

While in part the run-up in Japanese share market prices was due to fundamentals, such as unusually rapid economic growth, the market appeared to be overvalued; the price-earnings ratio on Tokyo stocks at year-end 1988 was 58.67 and the average estimated yield was only .51 percent. Every investment seemed to make money, and speculators were quick to jump on any new development. When American physicists announced that they had achieved cold fusion in the laboratory (a claim later shown to be unproved), eager Japanese investors ran up the share prices of firms that had any sort of relationship with potential cold fusion processes. In retrospect, it appears that by year-end 1988 the Japanese stock market was in the midst of a full-fledged bubble.

The bubble economy was not limited to the stock market. Sharp price rises were also observed in real estate markets, especially in Tokyo, beginning in 1986, where prices more than doubled in four years. Residential prices in Tokyo rose by approximately a 70 percent annual rate in 1988, while Tokyo commercial real estate rose by close to 80 percent. Tokyo prices stabilized in 1989, other areas, such as Osaka and Nagoya, began to increase rapidly; and prices in Tokyo began to increase again in 1990.

The causes of the real estate boom are still being debated, but the main factors appear to have included the following. First, the heavy concentration of economic activity in the Tokyo area created an upward pressure on the value of the fixed supply of land. Second, the Bank's loose monetary policy increased land prices, both by stimulating economic activity and by driving down the price of mortgage loans. Third, Japan's banks, facing competition from the securities industry for their core commercial lending business, sought to develop new markets in small and medium-sized firms, and especially in real estate development, in order to maintain their asset size in a more competitive environment. Fourth, people wanted to buy real estate in order to shelter earnings against inheritance and income taxes. Fifth, once the trend toward price increases was well-established, demand fed on itself, increasing because of speculation rather than fundamentals.

The property and equity market booms were closely related. Increases in real property prices enhanced the collateral value of individual assets, thus facilitating loans secured by property for the purchase of buying securities. At the same time, as increased demand drove up security prices, securities held by an investor (usually, a corporation) could be used as collateral for loans for the purchase of property. Increases in real estate values placed home ownership out of reach for many younger Japanese; they continued to live with their parents and saved money, both because of lower housing costs, and because they needed to save more if they were ever to own their own homes; these increased savings, in turn, channeled even more funds into equity market investments. In addition, many corporations and banks had extensive portfolio holdings of either equity securities or real property; increases in the value of their holdings would be translated into increases in their share prices.

Because of the phenomenal price-earnings ratios being realized on the Tokyo market, new issues of equity securities could bring in funds at very low cost. It was not actually necessary to sell equities in order to raise capital; a huge market in warrants developed in the Euromarket, where buyers snapped up rights to purchase equity shares in Japanese corporations in the future. It must have seemed inevitable to many purchasers of these warrants that they would realize a hefty profit at time of exercise.

Some corporations went to the market, moreover, not to fund current operations or to invest in plant or equipment, but simply to obtain cash which they could bank for future needs. Other firms began to speculate in stocks in order to realize profits rather than to concentrate on their core businesses -- a strategy known as "zaitech".

The huge boom in equities had a mixed effect on the banking industry, traditionally the leading source of financing for Japanese corporations. Many of the banks' best customers substituted equity financing for bank financing, since they could obtain funds more cheaply in the equity markets than through a bank loan. Thus the banks continued to lose market share to securities markets, a phenomenon which had been underway even before the speculative economy took hold, and which was accelerating in any event as a result of extensive deregulation in the Japanese financial system since 1984.

At the same time, the banks themselves were profiting from the boom. Japanese banks were under a deadline to comply with the capital adequacy rules adopted under the auspices of the Bank for International Settlements in Basle; as part of the Basle Accords, they could count 45 percent of unrealized appreciation in their portfolios of equity securities as Tier II capital for purposes of the risk-based capital rules. As the stock market soared, the banks found their capital positions strengthening in a most satisfying way. In addition, the banks themselves issued substantial amounts of new equity, further strengthening their Tier I capital positions.

The loss of many larger corporate customers to securities markets was a blow to the banking industry, but the enormous amount of real estate development that was occurring as a result of the asset boom gave the banks a new source of loan customers. At the same time, the increased supply of bank financing for real estate-based loans further increased the demand for real estate, driving up its price even further. The cost to the banks, which would not become fully apparent until after the bursting of the bubble, was that they were exposed to downturns in asset prices, as well as to the business losses that their borrowers would experience when conditions worsened.

BOJ began to act against the land and share price bubbles in 1989. It tightened monetary policy in a mild way at the end of May, 1989, when it raised the official discount rate for the first time in nine years -- from 2.5 percent to 3.25 percent. In addition to raising the explicit discount rate, the BOJ appears to have adopted a more restrictive monetary policy in its open market operations around this period in mid-1989, at least if market rates are an indication: short term interest rates rose a full percentage point between January and June, 1989. On October 11, 1989, the BOJ raised the discount rate again, from 3.25 percent to 3.75 percent, following rate rises by the Bundesbank and other central banks. The indications of a more restrictive monetary policy at the BOJ could be seen in short term rates, which climbed throughout the Fall of 1989, closing the year at 6.25 percent.

Despite the rising rates, the market continued at near-record levels. By the end of August, 1989, the Nikkei 225 had topped 35,000, continued in this range through November, and then rose again through the end of the year. The property boom continued as well. Although administrative guidance from the Ministry of Finance had reduced the amount of credit available for Tokyo land purchases, thus holding prices in the capital fairly steady in 1989, prices rose by over 90 percent in the adjacent prefecture of Chiba, 37 percent in Osaka, and 28 percent in Kyoto.

The market ended 1989 on a buoyant note. The Nikkei 225 was trading over 38,000, and appeared poised to jump over the psychologically important 40,000 level soon after the new year. Asset prices continued upward. Fueling the run-up in share and asset prices was a sense of euphoria that seemed to infuse the entire market. Although the economy was racing and unemployment was a minuscule 2.2-2.3 percent during the Fall 1989, there were few signs of inflation; consumer prices were rising only at about 2.3-3.0 percent. Japan appeared to have achieved the impossible: it was sustaining full employment, low inflation, high economic growth, a large trade surplus, and enormous rises in property and share values. No wonder the market was euphoric; it was difficult at this time to find a measure of economic performance that counseled caution -- other than the sense that this sort of condition was too good to be true.

Author:

Dr. Geoffrey P. Miller

email: millerg@turing.law.nyu.edu

Professor of Law and Director,

Center for the Study of Central Banks

New York University Law School

40 Washington Square South Suite 411G

New York, N.Y. 10012

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