Geoffrey P. Miller
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
Geoffrey P. Miller*
SECTION - I
Abstract: In recent years, price bubbles appear to have developed in the real estate markets in several developed economies, including the United States, Australia, the United Kingdom, the Nordic countries and Japan. Often these price increases in land have been accompanied by rapid run-ups in the price of equity securities in the domestic market. Because of the importance of real estate and equity security prices to economic activity, real estate and share price bubbles can damage the economy if they break and lead to price crashes. These bubbles pose an intriguing question of political and economic organization, and raise questions about the efficacy of central bank intervention. By tightening monetary policy and raising interest rates, the central bank can inhibit or even destroy a bubble. On the other hand, there are a variety of factors -- legal, political, and technical -- that make it difficult for central banks to intervene effectively in bubble economies. This paper explores the problem of the role of central banks in bubble economies in the context of the role of the Bank of Japan in the notorious price bubble of 1989-90.
I conclude that, in general, the central bank should not be charged with principal responsibility for policing against price rises in discrete industrial sectors. At the same time, central banks have a legitimate role to play in controlling bubble economies. Because central banks monitor economic developments in their economies, they should track asset prices in different industrial sectors. Where a bubble becomes so large as to pose a threat the entire economic system, the central bank may appropriately decide to use monetary policy to counteract a bubble, notwithstanding the effects that monetary tightening might have elsewhere in the economy.
“How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.”
- Alan Greenspan (December 5, 1996)**
“Regrettably, history is strewn with visions of . . . ‘new eras’ that, in the end, have proven to be a mirage. In short, history counsels caution. Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years. These gains have obviously raised questions of sustainability . . . Why should the central bank be concerned about the possibility that financial markets may be overestimating returns or mispricing risk? It is not that we have a firm view that equity prices are necessarily excessive right now or risk spreads patently too low. Our goal is to contribute as best we can to the highest possible growth of income and wealth over time, and we would be pleased if the favorable economic environment projected in markets actually comes to pass. Rather, the F.O.M.C. has to be sensitive to indications of even slowly building imbalances, whatever their source, that, by fostering the emergence of inflation pressures, would ultimately threaten healthy economic expansion.” ***
- Alan Greenspan (February 27, 1997)
“We don’t view monetary policy as a tool to prick the stock market bubble.”
- Alan Greenspan (March 5, 1997)
In recent years, price bubbles appear to have developed in the real estate markets in several developed economies, including the United States, Australia, the United Kingdom, the Nordic countries and Japan. Often these price increases in land have been accompanied by rapid run-ups in the price of equity securities in the domestic market. Because of the importance of real estate and equity security prices to economic activity, real estate and share price bubbles can damage the economy if they break and lead to price crashes.
These bubbles pose an intriguing question of political and economic organization, and raise questions about the efficacy of central bank intervention in an era in which the nation-state and its fundamental institutions are under pressure from a variety of pressures, technological, political, and economic. It is often the case that a bubble falls within the jurisdiction of no particular government agency. To the extent that an agency does have power, it may elect not to act because bubbles, while they are under way, are often extremely popular, and because it may be difficult to distinguish a speculative bubble from a price increase due to economic fundamentals. Thus bubbles are often unregulated, or (arguably) under-regulated in light of the risks they present.
One agency that will often have a degree of control over a bubble economy is a nation's central bank. This is because the central bank typically controls the money supply and short term interest rates. The money supply and interest rates, in turn, are key factors in the development and continuation of bubbles in real estate and equity markets. Such bubbles appear, typically, when interest rates are low and credit is cheap. By tightening monetary policy and raising interest rates, the central bank can inhibit or even destroy a bubble.
On the other hand, while the central bank does have a degree of regulatory power, there are significant costs and uncertainties that may make it difficult for the central bank to intervene. These include the following:
- A central bank's response to a share market bubble in its own economy may be influenced by concern for the effects on share markets in other countries.
- The central bank may be constrained by considerations of international relations, especially in the area of exchange rate policy: it may be difficult to harmonize the slow pace of international diplomacy on economic policy with the rapid developments in a bubble economy.
- The authority of a central bank to control a price bubble may be uncertain, because the bubbles may not affect the broader economic indicators typically relied on by central banks in formulating monetary policy.
- The economic sector in which the bubble occurs will often be within the regulatory jurisdiction of an institution other than the central bank, and thus the central bank may face bureaucratic opposition to any intervention.
- The bubble economy may be the result, in part, of financial deregulation which has the effect of directing bank credit into particular economic sectors, especially real estate. Depending on applicable law, the central bank may not have the authority to deal with the underlying root causes of the credit surplus.
- The tools available to the central bank to act against bubbles are likely to have effects on economic activity outside the bubble, and accordingly a central bank must use these tools with caution.
- Any action by the central bank against a price bubble is likely to encounter political opposition from a variety of sources: interests which profit directly from the bubble, interests which, while not profiting directly from the bubble, would nevertheless be harmed if the central bank tightened monetary policy, and members of the public who are swept along in the general euphoria.
- The central bank's ability to act against a bubble economy during the early stages is likely to be adversely affected by uncertainty about whether the phenomenon is really a bubble, or rather a series of price increases based on economic fundamentals.
- The central bank may need the support of politicians if it is to act decisively against a bubble economy, especially during the early stages when the price increases are likely to enjoy widespread popular support. If such support is not forthcoming, the central bank may not be able to take firm enough action to deal with the situation.
- The power of a central bank to act against a bubble economy may depend on the bank's own political position; other things equal, a politically independent central bank is likely to have somewhat greater discretion to act against a bubble than a politically dependent one.
In this paper, I explore these questions concerning the role of the central bank in responding to land or share price bubbles. I do so in a particular context: the Japanese real estate and share price bubble of the late 1980s.
The bubble economy in Japan during 1988-90, when Japanese land and share prices more than doubled, was one of the most remarkable examples of financial speculation in modern times; in absolute terms, it was possibly the largest speculative event in the history of the world. The peak of the bubble economy lasted only about two years; the bubble popped in 1990. Between 1990 and 1992 the Nikkei 225 average lost over sixty percent of its value, and land prices plummeted by about fifty percent. The effect on the Japanese economy was adverse: the country entered a recession of unusual duration and severity, corporate bankruptcies soared, and the banking sector suffered severe bad loan problems which are still far from being resolved.
The Bank of Japan (BOJ) played a role in the bubble economy. During the period immediately before and during the bubble, the BOJ kept interest rates low and adopted a loose monetary policy. The Bank finally began to tighten policy in the Spring of 1989 and continued to tighten during 1990, actions which may have contributed to the collapse in 1990. The Bank was aware as early as 1987 that asset prices might be growing at an excessive rate and that real estate lending posed potential dangers to the banking system. If the Bank had acted earlier to tighten monetary policy, some of the subsequent costs might have been avoided. In the words of one distinguished Japanese economist, the Bank's failure to act was a "major mistake." Why did the Bank delay?
I conclude that the Bank delayed for many of the reasons outlined above. The Bank faced technical, legal, and political problems which made it exceedingly difficult to intervene earlier. The case history suggests, consistent with the theoretical analysis, that central banks are poorly situated to respond to price bubbles in particular industrial sectors. The central bank's role in responding to these phenomena is accordingly problematic.
In general, one can conclude that the central bank should not be charged with principal responsibility for policing against price rises in discrete industrial sectors. That responsibility should be exercised by other authorities, with awareness of the general social utility of allowing the price system to operate free of government intervention. If these authorities do intervene, they should use regulatory tools designed to have effect only in the affected sector and not elsewhere.
At the same time, central banks have a legitimate role to play in controlling bubble economies. Because central banks monitor economic developments in their economies, they should track asset prices in different industrial sectors. If the central bank observes a problem in a particular area, it can alert the appropriate authorities. In rare cases, where a bubble becomes so large as to pose a threat the entire economic system, the central bank may appropriately decide to use monetary policy to counteract a bubble, notwithstanding the effects that monetary tightening might have elsewhere in the economy.
The analysis in this paper is based both on published sources, and on off-the-record interviews with high-level officials in the Japanese government who are familiar with the events in question. The paper is structured as follows. Part I describes the origins, development, and demise of the Japanese bubble economy. Part II analyzes the problems a central bank may face in dealing with a bubble economy, and considers whether these problems affected the Bank of Japan during the period under review. I end with a brief conclusion.
SECTION - II (next week)
Dr. Geoffrey P. Miller
Section - II Section - III