• The JSBF Report

Japan’s “Bubble Economy”


- By Rohan Roney John


Source: strategicalpha.com



Introduction


Asset price bubbles have been responsible for devasting recessions and economic downfall for many economies, from The Dutch Tulip bubble in the 1630s to the Real estate bubble in the US, Britain, Spain, Ireland, and Iceland from 1995 to 2000. Before diving deeper into a historic event of a bubble, it is crucial to understand the concept of an asset price bubble. A continual upsurge in the price of a financial asset or commodity, to levels greater than its intrinsic or fundamental value, is titled an asset price bubble. A bubble tends to sustain due to the market’s expectation of a future increase in prices for an asset, attracting new buyers. A price bubble can be categorized as an unstable equilibrium, where forces of demand and supply are unable to correct price deviations in the market. However, the bubble ultimately bursts as prices crash and demand plummets, resulting in a decline in the economy.


There are five stages of an asset price bubble: Displacement, Boom, Euphoria, Profit taking, and Panic. In the first stage, displacement, where investors believe a new economic paradigm has occurred due to factors such as new technology, low-interest rates, et cetera. Followed by the second stage, boom. In this stage, the prices start rising subsequently to a displacement. More entrants enter the market, and the asset in play receives immense limelight and popularity. This fosters more speculation, multiplying the participants in the market. In stage euphoria, the asset price has skyrocketed and the “Greater Fool” theory comes into effect. During stage 4, a minority of the investors observe warning signs and sell their position to earn their profits. Lastly, during the panic stage, asset price runs a reverse course as it starts declining rapidly. Investors are willing to liquidate at any given price to avoid heavy losses. The demand is much lower than the supply, resulting in a further price decline.


Now that the concept of an asset price bubble is explained, in this report, my primary focus will be on the Japanese real estate and stock bubble of 1985-90. The study will emphasize the main reasons behind the formation of this bubble, the effect on the domestic and foreign economy, and lastly, the steps taken to contain the bubble. The report will also include my arguments.



I. History of Japanese asset price variations


The Japanese economy has gone through 3 major asset price crest-trough cycles post-World War II: the Iwato Boom, the “Remodelling the Japanese Archipelago” boom, and the Heisei boom (Shiratsuka, 2005) as seen in figure 1.


Figure 1: Asset price fluctuations post-World War II

(Shiratsuka, 2005)


During the Iwato Boom, in the 1950s, the real economic growth was greater than 10% because of the growing investments in newer technology that replaced the reconstruction demand after World War II. Technological advancement resulted in an upsurge in asset prices. Prices bared by consumers also rose while the wholesale prices were steady, thus attaining “productivity difference inflation (Shiratsuka, 2005).”


Throughout the “Remodeling the Japanese archipelago” boom the economy observed an asset price surge, followed by a rise in general price levels. This was caused due to exceptionally high growth in money stock and oil prices stemming from the first oil crisis. This period of economic boom ended due to a prompt fall in real economic growth.


During the Heisei boom, also known as the “bubble period (Shiratsuka, 2005),” which occurred between 1985-90, the economy observed a dramatic rise in asset prices, especially the real estate and capital market due to “overheated” economic activity, unconstrained money supply as a result of the unnecessary easing of monetary policies, credit expansion, and various other factors. However, by the 1990s, asset prices rapidly plummeted and the economy declined for more than a decade. We will talk about the causes and effects of this bubble in detail in the upcoming section.



III. Emergence of the Japanese bubble


To understand the emergence of one of the biggest bubbles in history, let us go back to the 1980s. In the 1980s, the US dollar had appreciated by more than 50% against the Japanese, Yen, German Mark, French Franc, and British Pound (Cambell & Clarida, 1987). This resulted in exports becoming expensive and imports being cheaper for The United States, making the trade deficit grow to 3.6% of the total gross domestic profit (Griswold, 1998). Selling and exporting American products abroad became a growing concern in the United States. Pressure from the United States led the G-5, the 5 main industrial countries, to come into an agreement and devalue the US dollar through various policies, to reduce The United States’ trade deficit. This agreement was called the Plaza Accord. This caused the Yen’s value to appreciate relative to the US dollars. At the time of the Accord, the currency ratio between the United States and Japan was $1 to ¥240, and Japan planned on appreciating the Yen to ¥200 relative to one US dollar. However, Yen kept appreciating and fell to as low as ¥120/$1 (Hideo, 2016).


So, how did this affect Japan? Appreciation of the Yen put a strain on Japanese exports, by making exports relatively expensive, arising panics and alarms within the Japanese government and industries, specifically those that relied on exports. To avoid the risk of crisis the Japanese central bank and the government decided to introduce two main solutions, Fiscal and Monetary Policies. The Japanese government decided to increase its government spending to boost domestic demand and consumption. They also increased banks authorized by their government that began to loan enormous amounts to families and corporations to encourage more spending and investments. They also adopted expansionary monetary policy and cut interest rates to reduce the adverse effects of the Plaza Accord.


In response to the new policies implemented by the Japanese government, Japan, known to be an economy of “savers,”, citizens started making major investments in the real estate and capital market.


Real estate investments soared, resulting in skyrocketing property prices. As the value of real estate surged, so did the value of the collateral that individuals owned, thereby, strengthening individuals' ability to borrow more from the banks. Hence, starting the vicious spiral of the real estate bubble. Land prices surged to almost 5000 percent in Japan during the peak of the bubble (Parkes, 2020). The Japanese property market grew to such an extent that it was four times larger than the US property market and “land” accounted for 65% of Japan’s national wealth, whereas, the UK’s was 2.5 (Parkes, 2020).


Another key catalyst responsible for fuelling the bubble was the stock market, the market of speculation. When the government cut the interest rates, giant Japanese corporations started borrowing significantly large sums of loans to finance the purchases of shares, resulting in a rise in the share value. A greater share value meant greater profits for the company, and greater profits not only provided higher capital to the companies but also enabled companies to borrow more, thus, restarting the cycle. This formed a deeper speculative market. This technique, known as Zaitech, was employed by a majority of giant Japanese corporations listed on the stock exchange. It was estimated that 40 to 50 percent of the total profit of various Japanese corporations was generated through Zaitech (Picken, 2016). The Nikkei 225 stock market reached an all-time high of 39,000 points which initially started at just 11,540 points (Parkes, 2020).


This bubble fueled by real estate and the stock market can be summarized graphically, as seen in Graph 1 below.



Graph 1: The formation of the real estate and capital market bubble


Initially, the price of either the real estate or share price is P1 at the lowest demand curve. With the government’s implementation of policies after the Plaza Accord (as mentioned above), investors and traders believe that investing in the real estate and capital market could raise profitability and wealth, shifting the demand curve from D1 to D2, resulting in prices increasing from P1 to P2. This is the first stage of bubble formation, displacement. Subsequent to a displacement, investors and traders observed a price rise and hence, make further investments in response to the initial rise in prices, shifting the demand curve from D2 to D3, causing a further increase in prices from P2 to P3. This is the boom stage of a bubble formation. This process continues as investors and traders speculate that the prices will keep snowballing as the demand curve shifts rightwards, until the bubble reaches its peak, the third stage, Euphoria.


Japan’s bubble touched its peak in 1989, prices were so high that affordability was out of reach for young people, that banks developed one-hundred-year and 3 generation mortgages (Kindleberger & Aliber, 2005). Eventually, the bubble burst. Inevitable?



IV. The beginning of the end: “Lost decades”


In response to the dramatic rise in prices, the government and central bank decided to gradually stop the expansionary monetary and fiscal policies, and simply, the bubble burst after. A bubble burst can be represented graphically as shown in graph 2. The demand and supply curves shift together, resulting in a reduction in prices from P1 to P2.


Graph 2: The Japanese bubble burst


Banks were told to reduce the rate of growth of loans so that it would not be greater than the rate of growth of their total loans. When the rate of growth of bank loans decreased, individuals that recently invested in real estate were in a position of a cash crunch. Their income from real estate became lesser than their interest payments on mortgages. Moreover, they could not borrow more loans to repay these outstanding interest payments, hence, they started selling their properties to avoid the heavy costs of maintaining them. Following a similar trend, the stock market also fell. The decline in both these sectors can be observed in figure 2 below.



Figure 2: Land prices and stock prices (the 1990s) (Ignore the CPI excl fresh food curve)

(Shiratsuka, 2005)


As depicted above, the land prices declined, and major corporations and banks faced serious problems of liquidity and solvency. This made banks even more inhibited in giving out loans. In addition, the stock exchange shrunk by a total of 60%, 30% in 1990, and an additional 30% in 1991 (Kindleberger & Aliber, 2005). The financial technique, Zaitech, now functioned in reverse, not only did it not add value but started subtracting it. As Japanese stock valuation started to plummet, the value of The United States’ stock exchange rose, as traders in the global stock market, sold Japanese shares to purchase US shares.


The implosion of the bubble had taken away the wealth and prosperity of the entire Japanese economy. From an economic boom to an economic crash, Japan was experiencing deflationary effects, investments declined, the cost of capital increased, business profits reversed, and household spending plummeted due to increased savings of families to compensate for losses incurred during the bubble. Japanese corporations started promoting and selling their products abroad as the domestic market was growing relatively slower compared to the foreign market. However, that resulted in the Yen appreciating as exports grew bigger than the total imports, making exports expensive for export-oriented Japanese companies.


Till 2000, Japan continued facing low GDP growth and economic stagnation, the “Lost Decade.” Following that, no matter what policies the Japanese government implemented, the Japanese economy appeared to be recalcitrant and unresponsive. Japanese people had lost confidence in banks and were holding their money instead of depositing it because they believed banks were unreliable. They were only prepared to invest in government bonds, which enabled the government to spend money on the welfare sector, such as dams, bridges, and other public goods, to generate new jobs and stimulate the economy, but this only had a brief impact (Goel & Gupta, 2017).



V. Do bubbles exist?


The Japanese Bubble Burst of 1989 demonstrates how bubbles can emerge in an economy. Several notable economists even disagree with the existence of such "bubbles".


Eugene Fama and Robert Shiller, two notable economists believe that bubbles do not exist. Eugene Fama stated that the word “bubble” is meaningless. He feels that following the price drop, individuals find it simple to claim that the economy was in a bubble. Robert Lucas agrees with Fama's approach, claiming that it is difficult to construct a prediction model that accurately predicts the value of any financial asset plummeting in value. Even if it were conceivable, it would be public knowledge, and traders and buyers would be able to forecast the decline and pop the bubble sooner.


Markus Brunnermeier, on the other hand, believes that while the bubble could burst sooner than expected if investors are aware of it, each investor will have no idea when other participants start withdrawing investments and trading against it. This drives investors to be cautious, fearful that if they wait too long for other buyers and investors to react, they would be unable to exit the bubble without suffering significant losses. As a result, every investor will be wary of being the first to 'lean against the wind,' as they may choose to stay invested in the bubble till the end to maximize earnings.


While economists might dispute the occurance of bubbles, central financial institutions authorities must constantly monitor rising bubbles and assist investors in trading against asset price bubbles. As witnessed in Japan, attempting to revive the economy after the burst is not sufficient; preventative efforts must be done to decrease the bubble as soon as it is identified.


Because there was obvious evidence that the Japanese economy was operating in a market with high levels of inflation, the Japanese Bubble Burst is crucial in this debate of whether a bubble exists or not. The Japanese stock market had surpassed that of the United States, the value of the yen had skyrocketed, people could no longer afford to purchase real estate in Japan, and golf club memberships were being auctioned for millions of dollars. Furthermore, the trading frenzy was a sign of irrational exuberance and a vicious cycle of constant speculation that kept price fluctuations. Most people overlooked these obvious indicators because they were caught up in the excitement of savoring their fortune, but a few traders and investors saw them and shorted out.


Markus Brunnermeier was proven correct in this situation. Even though some investors realized they were all in a bubble, they followed it to the finish line to recoup their investment and earn profits, and that is why the bubble didn't burst until the Bank of Japan raised interest rates.


Obviously, every bubble appears to be preventable and apparent after it bursts, and perhaps I'm operating with hindsight bias, but bubbles could indeed exist and have unmistakable indications, as the Japanese Bubble Burst demonstrated.



Conclusion


In Japan, the years between 1985 and 1990 were a time of unprecedented prosperity. In just 3 decades, Japan went from being a worn-torn country to becoming a financial and industrial powerhouse, largest international creditor and one of the wealthiest countries. Wealth, prosperity, and decadence epitomised the age. It was also predicted that Japan's economy would overtake that of the United States, making it the world's most powerful economy.


The prediction, though, remains just that: a prediction. In truth, as explained in this report, Japan had a massive financial crisis from which it has yet to fully recover, even 30 years later.


Was avoiding the Japanese bubble a possibility? Avoiding any economic bubble is not possible. If an economy goes through an elevated growth in the economy, it is likely for an economy later fall as part of a cycle. However, it is possible to minimize the severity of a bubble burst. During an era of information being accessible, not freely, but available, identifying a bubble is crucial. Recognizing the emergence of the bubble would have aided in

understanding the dramatic aftermath too.


Was the government’s intervention effective? Not particularly, since the Japanese government made a series of blunders that encouraged corporations and individuals to further fuel the bubble until it reached a stage of extremity. The government’s loose and ineffective monetary and fiscal policies instigated an inexorable bubble burst recession into decades of stagnation and deflation. It can be said that the Japanese government let the party go on until it was too late to save its economy from an economic downturn.


I do agree that it is easier to talk about containing a speculative bubble and it would be impractical to talk about circumventing bubbles completely. Nevertheless, implementing the right course of action to deal with the bubble during and after its burst is essential.



 


Works Cited


Shiratsuka, S. (2005). The asset price bubble in Japan in the 1980s: lessons for financial and macroeconomic stability. Japan: IBIS . Retrieved from https://www.bis.org/publ/bppdf/bispap21e.pdf


Cambell, J. Y., & Clarida, R. H. (1987). Campbell, JohnHARVARD Clarida, Richard. Havard University.


Griswold, D. (1998, July 22). America’s Misunderstood Trade Deficit. Retrieved from Cato Institute: https://www.cato.org/testimony/americas-misunderstood-trade-deficit


Hideo, T. (2016, April 14). Japan Forfeits 30 Years to the Gyrations of the Yen. Retrieved from Nippon: https://www.nippon.com/en/column/g00350/


Parkes, D. (2020, July 1). Japan in the 1980s: when Tokyo’s Imperial Palace was worth more than California and golf club membership could cost US$3 million – 5 crazy facts about the bubble economy. Retrieved from Style.


Picken, S. D. (2016). Historical Dictionary ofJapanese Business. Rowman & Littlefield.


Kindleberger, C. P., & Aliber, R. Z. (2005). Manias, Panics, and Crashes. John Wiley & Sons.


Goel, A., & Gupta, T. (2017). Japanese Asset Bubble. Kanpur: IIT Kanpur.





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