Asset Bubbles, Market Crashes, and the Dilemmas for PolicymakersBubbles seem to occur every two or three generations—learning from history and making serious reforms to lessen the economic havoc that follows in their wake requires solid determination
Financial history is marked with times when populations took collective leave of their senses and succumbed to delusions of ever-expanding wealth. Times of self-defeating speculation have followed periods of stability and the introduction of new technology. The supposed new wealth more often than not was a mirage, with generations being scarred by the speculative experience, returning them to more traditional financial values. It should be the goal of economic policymakers to better understand the causes of bubbles to minimize their very considerable economic costs.
Stock markets are by their very nature volatile. They reflect the collective hopes and fears of traders and investors, with all known factors supposedly being discounted and reflected in the market price. This volatility is normally a healthy and self-correcting mechanism. But occasionally, excessive liquidity coupled with visions of a new era causes risks to be downgraded among participants, thereby engendering a massive, largely uncorrected rise in valuations that discounts not just the present and the near future, but a distance far over the horizon as well.
Some Historical Bubbles
Perhaps the earliest modern bubble was the Dutch tulip craze in the 1600s, when supposedly rare tulip bulbs were traded at such increasingly ludicrous prices that some good burghers were willing to trade the family farm for a single bulb. They may have believed the bulb was really worth this amount; more likely they hoped that a bigger fool would later give two farms for the bulb. The bursting of the bubble led to enormous personal financial distress but established the tulip industry, which is still an important export market for The Netherlands.
Britain—as the first country to industrialize on the basis of stock market finance—had a history of bubbles in the 19th century, based on canal and railway finance, first in Britain, and then increasingly overseas as investment followed the flag. But it is in the United States (US) where the largest bubbles have occurred at regular intervals over the past 200 years. These major speculative bubbles have usually been related to the introduction of new technology that promised untold economic growth and riches.
The building of the cross-country railroads and the opening of the western US led to the greatest speculation in the 19th century. Unlimited visions of easy wealth attracted money from around the world for financial propositions that were never viable, with small investors almost inevitably ruined by the resulting collapse. Some railroads survived, but often the survivors became successful enterprises only through mergers and recapitalizations in the wake of the crash. Initial investors saw little or no return.
The US boom of the 1920s had as its rationale the introduction of electric power utilities and promises of new efficiencies for an urbanizing and industrializing population—financed through the stock market. Although they were essentially mundane businesses with modest and predictable rates of return, they were increasingly packaged as high-return instruments through an early form of financial engineering—speculative and had no earnings and no realistic earnings expectation, companies were “valued” at multiples of possible distant revenues. leverage investment trusts—to increase their appeal with promises of instant wealth. The inevitable collapse and its aftermath have been well documented.
The wild expansion and speculation of the 1990s were related to the Internet and liberalization of the telecommunications market but followed in the steps of the earlier infrastructure-related booms and busts. Many new companies essentially were frauds worth no more than a dream. For them to be sold, the financial establishment developed new valuation methods. As the companies had no earnings and no realistic earnings expectation, companies were “valued” at multiples of possible distant revenues. Inevitably, the façade eventually collapsed.
The costs of the 1990s bubble have been hugely disproportionate to gains. Losses to the economy from the stock market alone have already reached the equivalent of the value of the US GDP—and could well go higher. As greed consumed the players, restraints on the system itself broke down and became increasingly corrupted. Bankers, accountants, auditors, corporate boards and executives, legislators, and regulators all are to some degree responsible.
This first mass global speculative mania has weakened the important life insurance industries and corporate pension plans on several continents. This will not only impact the lives of people directly through less financial security but will also lead to slower economic growth and reduced living standards for years to come. Legislative and regulatory measures are being put in place to make sure the same errors are not repeated in the future.
Asia avoided major bubbles until the late 1980s, when Japan suffered its “bubble economy,” focused on real estate and the stock market. As the culmination of 40 years of economic expansion, Japan’s excess savings were funneled into property and stock markets, driving markets to ludicrous valuations. At the peak, the value of the land in metropolitan Tokyo was supposedly greater than that of all the US. In the stock market, Japan’s system of corporate cross-holding artificially restricted share supply, causing price-to-earnings valuations to soar to unheard of levels.
Losses from the burst bubble have led to a lost decade of growth that has crippled the banking and insurance sectors and depressed the economy. Japan’s economy today is probably 20–25% lower than if a relatively modest 3% growth rate had been maintained since the markets peaked in 1990. This potential output gap will grow in the coming years and reflects the costs of failing to manage the bubble.
Developing Asia, especially Northeast and Southeast Asia, were global development success stories from the 1950s until the Asian financial crisis of 1997. In many ways, success followed the successful Japanese model of building on export competitiveness, high savings rates, and rapidly growing and increasingly well-educated labor forces that could serve their export industries. But financial markets as well as legal, regulatory, and corporate governance systems did not modernize at the same rate as the real economies.
A long period of outstanding growth, together with what must now be seen as ill-timed financial liberalization, led to an all-encompassing overconfidence. Ease of finance led to excessive volumes of property being built with inappropriate foreign currency borrowings. The subsequent bust wrecked the financial systems in several Asian countries, leading to severe dislocations and years of substandard growth.
Lessons for Policymakers
Bubbles are not new. They seem to occur every two or three generations as economies develop—long enough for those presently living not to have experienced earlier booms and busts. In the US, the interval between the recent bubble and the previous one in 1929 is longer than that between previous bubbles. That reflects the relative success of the financial regulatory mechanisms introduced in the 1930s.
The recent US bubble, however, also reflects a failure to update and modernize regulatory measures adequately as new financial practices evolve. Incompletely thought-out deregulatory measures—for example, deregulation for local telecommunications companies, elimination of the Glass Stegall act separating commercial from investment banking, and the wild growth of the opaque derivatives markets—have all contributed. A failure to learn from earlier bubbles has also contributed.
In the case of central banks, new monetary policy techniques may have to be introduced in this era of globalization. The Bank for International Settlements has been studying this issue. In particular, focusing on domestic consumer price indexes as the sole measure of inflation while ignoring booming asset markets has meant that liquidity conditions have been too easy for too long. Greater cognizance of asset markets would seem essential for good monetary management in the future.
But the tools alone will never be sufficient. Political will to use them is also needed. It is often said that the duty of a central bank is to take away the punchbowl when the party is getting merry. In other words, central banks should be anticyclical, not pro-cyclical. But despite their supposed independence, central banks operate in the political world.
It appears that the Japanese central bank knew it had a bubble for several years before it acted. Similarly, the US Federal Reserve Board knew in 1996 that a bubble was brewing when its Chairman spoke of irrationaexuberance. Further, it knew that raising share margin rates could have stopped the bubble before it grew to excessive levels. But a combination of factors—the fear of domestic political and legislative consequences of reining in a bull market, and a succession of international events, including the Asian, Russian, long-term capital market, and Y2K crises—were all rationalizations for inaction, as was the apparent conversion of the Fed Chairman to the nostrums of a productivity miracle in the new economy. The irony is that the so-called productivity miracle may itself be the product of new-age government accounting rather than a genuine phenomenon.
Implications for ADB
As part of its policy agenda, the Asian Development Bank works with its member countries in improving the transparency and integrity of its members’ banking, financial and bankruptcy systems. Since the crisis, credible progress has been made in the Republic of Korea and most Southeast Asian countries. Regional economies are improving and, with their justly famed flexibility, have fared quite well in the present global economic downturn. But a natural tendency also exists for member countries to back off from sensitive reforms as their economies improve. With an uncertain global economic outlook and intense competition for foreign investment, ADB needs to keep up the pressure for change in these areas as well as the related field of corporate governance. Asia remains better placed to grow out of its problems than the more developed areas with older populations.
William R. Thomson
23 December 2002
Reprint Permission courtesy of Asian Development Bank
William Thomson is Chairman of Momentum Asia, the Asian arm of a manager of alternative investments, and Chairman of the Siam Recovery Fund. He was with the Asian Development Bank from 1985 to 1995 as a member of the Board and as a Vice-President. He is a former US Treasury official, and writes widely on economic and financial issues.
Viewpoint is a regular feature of ADB Review. Prepared by a senior journalist, academic, or analyst, the articles are meant to provide fresh perspectives and stimulate debate on development issues. The material in this article does not necessarily reflect the official views of ADB.
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