Asset prices are at the forefront of the current economic crisis. Housing prices in the US were on a steady rise between 2000 and 2006, leading to what is termed an ?asset price bubble?, which then burst in 2007 when consumers began to default on sub-prime mortgages. This led to an increase in risk premia of securities that used these mortgages as underlying assets, which led into a credit crisis that eventually resulted in a synchronised global downturn.
The question of what caused this bubble in the first place has received a lot of attention, both in popular press and in academia. One outlet of this attention is studying historical precedent. This is easy because, ironically, economic bubbles are by no means a new phenomenon. Starting with the historic inflation in the prices of tulips in 1637 (at one point, the price of a single tulip bulb equalled that of a luxury house in 17th century Amsterdam), to the dot-com bubble in the US in early 2000 and the current housing bubble – asset price bubbles are no strangers to economists. One recent such study is by Robert Barsky of the University of Michigan. In an NBER paper titled ?The Japanese Bubble: A ?Heterogeneous? Approach?, Barsky examines the causes and context of the Japanese asset price bubble in the 1980?s.
Between January 1985 and December 1989, the real value of the Japanese stock market index (the Nikkei-225) tripled. So did the real value of an index of the Japanese real estate market. These two phenomenon are clubbed together as the ?Japanese Bubble?, which imploded in 1990 to result in the ?lost decade?, a ten-year period where Japan experienced near-zero economic growth. Why did this happen? Literature documents two behavioural reasons that may have sparked such an overvaluation?the fundamentals approach and the speculative approach.
The ?fundamentals approach? argues that investors believed that the period of high growth and low interest rates that prevailed between 1980-1985 in Japan would continue indefinitely. With increasing labour productivity, near-full employment, high GDP growth and loose monetary policy, there was a sound probability that Japan was on a high-growth path, and this reflected a fundamental shift in the Japanese economic story. One explanation for the overvaluation is that investors believed that this positive trend would continue indefinitely.
The second approach, which is the speculative approach, assumes the opposite. Speculation by definition is investment without a clear understanding of underlying fundamentals?for example, investment driven by herd behaviour, technical ?charting? analysis or the greater fool theory, which says that any investment is worthwhile as long as the investor can identify a ?greater fool? to whom you can sell the asset later for a higher price. This approach to understanding the Japanese bubble states that people did not stop to clearly evaluate the probability of an implosion?the general agreement was that stock and house prices would increase indefinitely. Asset values did not adequately reflect risk.
Barsky joins a growing group of academics who suggest that neither of these explanations fully account for the creation of the asset price bubble. They put forward a third, hybrid, explanation called the ?heterogeneity approach?. This acknowledges that not all investors in the market are subject to the same information and evaluation process, but under certain constraints, price equilibrium results in the opinions of bullish investors gaining precedence over bearish ones.
The reasoning behind heterogenous beliefs among investors moves beyond information asymmetry. Barsky studies data on aggregate consumption between 1985-1990, arguing that the expectation of a permanent rise in income (as in the fundamentals approach) should be accompanied by a permanent rise in consumption. This is not seen to be the case, which fits with the hypothesis of heterogenous beliefs . He also argues that the most important reason why the preferences of optimists are reflected to a greater extent in pricing is constraints on short-selling. By placing limitations on short-selling, you effectively curtail the ability of pessimists to express their market sentiment (that prices will fall), thereby increasing the weight of optimistic beliefs on final prices. When prices do start to fall, these pessimistic investors have two options?to enter the market and start buying, or to wait until prices fall further. Empirical evidence finds that in Japan, the latter case occured, resulting in an implosion of stock and house prices in 1990.
Does this place the entire blame of the bubble on financial regulation curtailing short-selling? No. The more important takeaway is the significance of information, and an ability to express your opinion based on such information. The sub-prime context revealed the importance of information. Other instances, such as the tulip mania and as this paper demonstrates, the Japanese bubble, reveal the importance of being able to use the information you have.
?The author works in Singapore