A Definition of Asset Bubbles in Economy

An asset bubble is a sharp deviation of the market value of an asset from its base cost. It is referred to the large-scale trade of goods or securities at a price that is completely inappropriate and overestimated. (Pride 87) This situation is associated with enormous demand for a certain product causing the price increase. In its turn, such price increase leads to the movement of the demand curve. There is no generally accepted theory explaining the emergence of the asset bubbles.

At the same time, the monetary liquidity is typical reason for the bubble development. Inappropriate standards of the bank lending, high volatility of the asset markets characterized by hyperinflation are likely to cause short-term speculative financial leverage. (Paterson) During the fall of the interest rates, investors generally do not want to keep their capital in the form of savings.

In order to benefit from the financial leverage the economic actors tend to purchase real estate or profit-gearing stocks. Moreover, the economic bubbles usually take place when different assets are overestimated in comparison with their fundamental price. In such case, the central bank is compelled to reconsider its monetary policy lowering the liquidity of the financial system in order to minimize the risk monetary collapse. Most economic researchers view the drivers of bubbles in the roots of inflation.

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Other theories believe that bubbles represent everything that is greater than its real value, so ultimate prices are likely to reset the fundamental values. (Pride) Furthermore, there are concepts of chaotic bubbles claiming that bubbles originate from the specific market conditions based on the interweaving of economic factors. Finally, some researchers consider the bubbles to be inevitable consequences of irrational valuation of assets (estimates not confirmed by fundamental factors).

The Theory of a Bigger Fool (TBF) relates the formation of an asset bubble to the irrational behavior of the market optimists (fools). Such players purchase overestimated securities with a view to resell such assets at higher price. (Lim, 58) In most cases, the bubbles continue growing until there are no reselling opportunities and then burst. It should be noted that the Austrian School of Economics believes that a favorable environment for the inflating bubbles is a combination of high inflation and low interest rates.

At the moment, three types of the asset bubbles based on the conditions of their formation and further dynamics are distinguished such as speculative, rational and churning. The speculative or traditional bubbles occur when the asset is acquired because the investor expects further increase in prices, but his expectations are not based on objective changes in the fundamental indicators. The theory of rational bubbles was pioneered based on the RET (rational expectancy theory). (Lim)

At the same time, the churning bubbles are caused by the asymmetry of information between clients and portfolio managers, as a result of which the manager has an incentive to conduct a large number of speculative transactions to maximize commission fees, depending on the number of transactions. Therefore, prices may not reflect the fundamentals of the issuing company.

The intrinsic bubbles represent the subgroups of rational bubbles characterized by its dependency on the dividend payments. For the purposes of this research it was decided to analyze the classic example of an asset bubble focusing on the case of Japan. Following the Second World War, Japan pursued a policy of stimulating exports and savings. Big savings increased the availability of credit, while significant trade surpluses led to strengthening the yen relative to other currencies, allowing Japanese companies to cheaply import technology and invest in production, thereby increasing their competitiveness and reaching the trade surpluses. Further strengthening of the yen has made financial assets extremely profitable

In the early 90's the country experienced serious problems associated with the collapse of the stock market and the real estate market. It is worth noting that the roots of the crisis lay in the welfare of the previous period. The second half of the 1980s was marked by the rapid growth of the market value of the Japanese assets. (Paterson) Dramatic increase of the market value of shares and land was largely speculative. It should be noted that the key drivers to the Japanese asset bubble were represented by the following factors.

Firstly, the high level of savings of the population negatively affected economic development. In the 1980s the average Japanese family postponed about 30% of its annual income. (Paterson) High level of savings has created a steady surplus of capital along with limited consumer demand. Secondly, since the beginning of the 80's, Japan has always had an active balance of payments for current operations.

The inflow of capital into the country created excess liquidity uncontrolled by the government. (Lim 35) The long-term export boom and the influx of citizens' savings caused a huge increase in deposits in the Japanese banks. At the same time, liquid assets of the banks were mainly invested not in the production lending, but in transactions with shares and real estate. The Ginza real estate prices peaked in 1989, at 100 million yen (about $ 1 million) per square meter. In other business regions, prices were insignificantly lower.

By 2004, A-class commercial property in Tokyo cost less than 1 percent of its peak price, residential real estate prices fell more than 10 times, but still remained the highest in the world until the second half of the 2000s. (Paterson 52) The conjuncture was supported by low interest rates and unjustifiably optimistic expectations of the continued growth of the Japanese economy. As a result, the Nikkei stock index grew more than four times in five years (1984-1989) almost to 39000. The cost of land in Japan grew in the 80's twice its previous level. Many Japanese have become millionaires judging by the market value of the assets held by them.

The Japan bubble is sometimes called psychological because the unpretentious and economical Japanese citizens humiliated by the defeat in the Second World War faced the fundamental mental changes feeling rich and successful. They began to spend a lot of money, especially when traveling abroad, and to argue about the deterioration of the economic systems of other capitalist countries, which were growing not so dynamically. At the same time, the Japanese people were taken abroad as wealthy and prosperous. Interestingly, even now this image of richness remains the same despite the fact that Japanese modest spending is no longer comparable to consumer insanity of the Arab sheikhs.

The Japanese economy was driven by a high level of investment, so the bust of the asset bubble had a particularly negative effect. At the turn of 1989 and 1990, the Japanese asset bubble burst. The beginning of the collapse forced the Bank of Japan to increase interest rates, but the decline was inevitable in any case. During 1990 -1994 the market price of financial assets of the country has fallen by more than 1000 trillion yen, which corresponded to GDP in more than 2 years. The Nikkei index dropped to 14,000 in 1992. (Paterson) Japan's economy entered a long stagnation period.

The country purported to deal with the bubble consequences unsuccessfully throughout the 1990s. Furthermore, continues to struggle the bubble outcomes even now. The companies engaged in financial speculation were ruined the first. Then the burst of the bubble hit the major realtors who bought land for developers under bank loans. (Pride 65)

Finally, the chain reaction captured construction companies spreading more and more widely. The fall of the land prices (approximately doubled) and securities in Japan led to the debt increase on the bank accounts and overall erosion of the Japanese own funds. (Paterson) This, in turn, led to the reduction of loans and capital investment as well as the collapse of the financial institutions. The subsequent economic downturn was accompanied by a further reduction in stock prices and land ownership, accelerating the weakening of the banks.

In the mid-1990s, several large banks were declared bankrupts. (Lim 111)Deflation has become serious economic problem caused by significant trade surplus because Japan exported significantly more than imported. As a result of the positive trade balance, the rate of the national currency was constantly growing, being the driving force of deflation. In the face of price deflation, domestic demand was shrinking.

Japanese customers postponed buying products waiting for cheaper offers. Consequently, the quality of goods was getting worse and worse. Deflation and the financial crisis have quickly led to the decline in production. Japan's economy, which became an example of the most impressive growth in the modern history of mankind, began to stagnate: the average annual growth in the 90's and 2000's was about 1.5%. The first increase in the cost of land in Japan after the crisis was noted only in 2005, when the land in Tokyo went up to a whopping 1%. (Paterson 52)

Only in 2007, real estate prices rose, but fell back again as a result of the global economic crisis. Bubble blasting lasted more than ten years, the stock market reached the bottom in 2003, but subsequently dropped to a new low in 2009 as a result of the global financial crisis. The consequence of the burst was a long period of economic stagnation, called the lost decade. (Lim 87)

Investments went beyond the country, manufacturers lost their technological advantage. Japanese goods became less competitive abroad. So, the Japanese Central Bank was forced to lower interest rates to almost zero. After it did not help to get out of deflation, some economists, in particular Paul Krugman, suggested using inflation targeting. The inflationary targeting means that the central bank publicly announces the growth of retail prices for the next year, or even using two-three-year horizon. (Pride 83)

Despite the legal acts initiated by the government, the country did not manage to reach the GDP growth stability at the level before crisis. Nevertheless, targeting policy was quite effective. The purposeful efforts of the government and the business community of the country, finally, brought the economy to the rails of stable, though very moderate, development rate.

An asset bubble is usually associated with trade of goods or more often securities at prices that differ significantly from the fundamental price. The Japanese financial bubble from 1986 to 1991is characterized by multiple increases in real estate and stock market prices. Bubble blasting lasted more than ten years, the stock market reached the bottom in 2003, but subsequently dropped to a new low in 2009 as a result of the global financial crisis. The consequence of the bubble burst was a long period of economic stagnation, called the lost decade.

In order to recover from the deflation, the Japanese government applied the targeted growth approach after zero lending rate failed to be effective. It should be noted that the bubble was caused by the initial export and price supporting policy applied by the Japanese government. Particular role was played by the trade surplus and favorable market conditions. It is inferred that the recession was inevitable outcome of the excessive growth of the Japanese economy in previous years.

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