6

Euphoria and Paper Wealth

Consider the birthdates of some of the tallest buildings in the world. The Empire State Building in New York City – 1250 feet tall – was started in 1929, at the peak of a bubble. In the late 1980s it seemed like eighty percent of the building cranes used to construct tall structures were in Tokyo. By the mid-1990s many of these cranes had migrated to Shanghai and Beijing, and then they moved to the Persian Gulf. Now the tallest building is the Burj Dubai in the United Arab Emirates, completed in 2010.

Tall buildings are as economic as the Pyramids in the Egypt. As the height of a building increases, the share of total floor space needed for elevators and non-rentable space increases in relation to the rentable floor space. Moreover tall buildings need to be ‘stronger’ since the lower floors must support the weight of more upper floors. (The higher the cost of land, the stronger the economic case for tall buildings – there is an abundance of land on the shores of the Persian Gulf and in Malaysia, if not in Tokyo and Hong Kong.)

These towers of eighty, ninety, or one hundred stories are a visual manifestation of asset price bubbles – and the willingness of governments and private firms to flaunt their wealth by reaching for the sky. A ‘mine is bigger’ syndrome. So, however, are the number of concert halls and the extensions of art museums and the student unions on college and university campuses. Many of these cultural centers are financed with gifts from wealthy individuals who have become much richer and more generous when asset prices have soared and economic euphoria was a growth stock.

The economic rationale for tall buildings is remindful of the remark of Willie Sutton, America’s most famous bank robber, on his choice of profession. ‘That’s where the money is.’ The surge in wealth in a bubble leads to economic behavior that would appear as exceptional – the squandering of wealth – in normal times.

The market for corporate jets soared between 2002 and 2007; there were waiting lists to buy the large Gulfstreams and impatient buyers paid several million dollars to buy the positions in the queue of those with earlier delivery dates.

The association between asset price bubbles and economic euphoria is also strong. One of the best-selling books in Tokyo in the late 1980s was Japan as Number One. The World Bank published The East Asian Miracle several years before the bubble in real estate prices and stock prices in Thailand and Malaysia and their neighbors imploded. Less has been heard of the New American Economy since the implosion of stock prices and the surge in the US fiscal deficit.

One feedback loop from increases in real estate prices and stock prices to the more rapid growth of GDP is from increases in household wealth to more household spending. Many households have savings or wealth objectives; as the surge in asset prices leads to higher levels of wealth they spend more on consumption goods – including conspicuous homes. (The mirror of increases in consumption spending is that the household saving rate declines.) The second loop is from the increase in stock prices to higher levels of investment spending; firms can raise cash from investors at lower cost and because of the decline in the cost of capital, they undertake new projects that would have been less profitable if this cost had not declined. Thus the ‘cost of capital’ to a firm varies inversely with the price of its stock; the higher stock prices are, the lower their cost of capital and the larger their investments in plant and equipment.

The cliché is that ‘stock prices are a leading indicator’ of changes in economic activity. The response is that changes in stock prices have forecast six of the last three recessions. US stock prices began to decline four to six months before the collapse of the economy at the beginning of the 1930s. The Japanese economy began to decline after stock prices started to fall at the beginning of 1990.

The relationship between changes in wealth and changes in spending is symmetrical; when asset prices decline, economic activity slows. During economic expansions business firms borrow more in response to the increase in their market value. Banks relax their loan criteria and increase their loans. When asset prices implode, the banks incur loan losses, and some banks may be so extensively de-capitalized that they are forced to close or to merge with a better capitalized institution or obtain capital from the government.

The strong correlation between the increases in asset prices and economic expansions leads to the question of whether the dominant influence is from changes in asset prices and wealth to the economy or whether instead the dominant influence is from changes in the rate of economic growth to the asset prices.

Albania was one of several former communist countries that experienced a Ponzi-type deposit scheme soon after its transition from a command economy to what was to become a market economy. Financial regulation was virtually non-existent during this transition. Entrepreneurs promised to pay interest at the rate of 30 or 40 percent a month. At such rates, wealth increased rapidly; for example, if the interest rate was 35 percent a month then 1000 leks deposited at the beginning of the year would amount to 64,000 leks at the end of the year. Depositors had every incentive to watch their money grow in the bank rather than to withdraw cash from the bank. Some Albanians dropped out of the active labor force because their incomes from the interest compounding were much larger than their wages and salaries. Others increased their spending because their financial wealth was growing so rapidly. The managers of the deposit arrangement always needed to attract new cash to offset the cash that was being withdrawn to manage the arrangement, in effect for the day-to-day living expenses of the managers.

When the deposit scheme unraveled there were lots of angry Albanians. Economic activity slowed rapidly because households went into a savings mode to compensate for the dramatic decline in their wealth.

Asset price bubbles – at least the large ones – are almost always associated with economic euphoria. In contrast, the bursting of the bubbles leads to a downturn in economic activity and is often associated with the failure of financial institutions, frequently on a massive scale. The failure of these institutions disrupts the channels of credit and thus contributes to the slowdown in economic activity and the sluggishness in the economic recovery.

Tulipmania

The price of Dutch tulips increased by several hundred percent in the autumn of 1636 – and the increases in the prices of the more exotic species of bulbs were even larger. Some analysts, especially those with a strong commitment to rationality and market efficiency, have questioned whether the use of the term bubble is appropriate to describe the increases in tulip prices. Tulip bulbs are subject to a cobweb-like growth behavior; once planted, a bulb may develop for six to eight months before it begins to bloom – and then each bulb produces many little bulbs.

Not only the exotic varieties of bulbs were affected; ordinary garden-variety tulips such as the Gouda, Switzer, or White Crown that were traded among simple folk at so-called colleges or public houses also soared in price.¹

The excitement around tulips began in earnest after September 1636, when bulbs were no longer available for examination since they had been planted to bloom during the following spring. Some of the buyers committed to pay for the ‘merchandise’ that was buried in the ground and that they could not see at the time of purchase. The excited bidding of November and December 1636 and January 1637 was conducted without any specimens in evidence.

The down-payments for the purchase of bulbs were frequently made by a form of barter.² Simon Schama, the historian, provided examples; in one case, for a pound of White Crowns (Witte Croon in Dutch, sold by weight because of its ordinariness) four cows were paid at the time of purchase and then Fl. 525 was to be paid on delivery (presumably the next June). Other down payments consisted of tracts of land, houses, furniture, silver and gold vessels, paintings, a suit and a coat, a coach and dapple-gray pair; and for a single Viceroy (rare), valued at Fl. 2500, two lasts (a measure that varied by commodity and locality) of wheat and four of rye, eight pigs, a dozen sheep, two oxheads of wine, four tons of butter, a thousand pounds of cheese, a bed, some clothing, and a silver beaker.³

The changes in the prices of tulips were not isolated from developments in the economy. The Dutch economy had been depressed during the 1620s when war with Spain was resumed after a twelve-year truce, but recovered impressively in the 1630s. The prices of shares in the Amsterdam Chamber of the Dutch East India Company doubled between 1630 and 1639, mostly after early 1636, going from 229 in March 1636 to 412 in August 1639, and then increasing another 20 percent to 500 by 1640. House prices had fallen in the early 1630s but ‘shot up’ in the middle of the decade. Investment surged in drainage schemes, in the West Indies Company and in canals.⁴ Jan de Vries wrote of the trekschuit, a system of horse-drawn passenger barge canals which got under way in 1636 and reached a ‘fever’ in 1640. Construction was undertaken between pairs of towns to make the travel of merchants and officials more dependable than by sailing ships, which depended on the wind. Two lines from Amsterdam to smaller towns were decided on in 1636, and one between Leiden and Delft. Building of the complex network reached a peak in 1659 and 1665, but de Vries connected the project to the tulipmania and to the explosive growth of the Dutch economy between 1622 and 1660.⁵

Jonathan Israel wrote that the tulipmania should be viewed against the background of the general boom and as a mania of ‘small-town dealers, tavern-keepers and horticulturalists’ while for the most part the wealthy made money in other ways.⁶ This perspective undermines one of Peter Garber’s points that there could have been no tulipmania because there was no depression once bulb prices declined.⁷ The Dutch economy slowed in the 1640s before putting on a tremendous growth spurt from 1650 to 1672, which involved luxury housing, civic buildings, and paintings. However the market for paintings collapsed with the French invasion of 1672.⁸ At the height of the boom there was a ‘mania’ for clocks and clock towers. In Leiden a clock was installed in a tower at the top of the White Gate where at the trekschuit station passengers were loaded and unloaded, to assure the punctuality of the personal barges.⁹

The decline in the prices of tulip bulbs led to a decline in economic activity, and the causal connection was that households were less eager spenders as their wealth declined.

The stock market and real estate

Many bubbles in stock markets are related to bubbles in real estate. There are three different connections between these two markets. One is that in many countries, and especially smaller countries and those in the early stages of industrialization, the market value of real estate companies, construction companies, and of firms in other industries closely connected with real estate including banks accounts for a relatively large share of the aggregate stock market valuation. A second connection is that individuals whose net worth has increased sharply as a result of the increase in real estate values buy stocks to diversify their wealth; there aren’t many other ways to diversify wealth. The third connection is the mirror-image of the second; the individual investors who have profited extensively from the increase in stock market valuations buy larger and more expensive first homes and they also buy second homes. The changes in the prices of apartments at the Manhattan real estate market are closely tied to the bonuses on Wall Street.

Homer Hoyt’s One Hundred Years of Land Values in Chicago¹⁰ traced five cycles of boom and relapse in real estate prices to the growth of Chicago. The boom in the US stock market in 1928–29 was linked to increases in prices of raw land, residential sites, and to commercial buildings in both the central business district and in the suburbs. Hoyt quotes from a Chicago Tribune editorial of April 1890:

In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit.¹¹

Chicago’s reputation for real estate booms was such that Berlin, overindulging in real estate speculation in the euphoria of victory over France in 1870–71, was called ‘Chicago on the [river] Spree’.¹² The booms in Berlin and Vienna in 1873 were related to the changes in prices on the New York stock market. One writer claimed that in Chicago in 1871, every other man and every fourth woman had an investment in house lots.¹³ The bubbles expanded in parallel until the summer of 1873.

The spread of euphoria from one market to another reflects that when asset prices are increasing at a rapid rate, the widows and orphans climb on the bandwagon. Capital gains can be made without any special skill. When asset prices collapse, shareholders know they are in trouble and must reduce their indebtedness; those investors who have high leverage recognize that their wealth is declining much more rapidly than stock prices and so they sell – or their positions are sold by their brokers and lenders.

Speculators in real estate initially feel no such compunction. Their debts are loans on extended terms, and not callable like day-to-day brokers’ loans. They have real assets, not just paper claims. Most choose to wait for the recovery that they think is just over the horizon.

The economic downturn leads to a drying up of the demand for real estate investments. Taxes and interest on loans, however, continue without interruption. Hoyt wrote that slowly but inexorably the speculators in real estate are ground down. The lenders to the real estate speculators, and especially the bank lenders, incur large loan losses. One hundred and sixty-three of 200 banks in Chicago in 1933 suspended payment. Real estate loans in default, not failed stockbrokers’ accounts, were the largest single element in the failure of 4800 banks from 1930 to 1933.¹⁴

Hoyt’s analysis of the relation between the stock market and the real estate market can be readily applied to the Japan of the 1990s. The large decline in property prices meant that many borrowers defaulted on their loans. The bank loans to credit cooperatives and other types of financial firms declined sharply in value because these lenders also had made real estate loans that often were underwater. Finally the decline in real estate values led to a sharp decline in banks’ capital since they owned large amounts of real estate.

The stock market’s troubles of October 1987 cleared up brilliantly after the monetary authorities rapidly increased bank liquidity to forestall a shortage of credit. Margin requirements of 50 percent helped. But the agony in real estate was drawn out. Construction slowed as buildings were completed, but new starts were abandoned or postponed. Vacancy rates in office buildings rose sharply, varying according to location, whether downtown, midtown, or in the ‘edge cities’ built in the suburbs during the 1980s boom.

Rockefeller Center Properties, Inc., had a $1.3 billion mortgage on the Rockefeller Center in midtown Manhattan after the complex had been sold to Mitsui Real Estate. The mortgage was held in a Real Estate Investment Trust (REIT). In 1987 the trustees sought to increase the income of the trust by using the cash from short-term loans to buy back bonds that were selling at a discount. The gains were paid out as dividends. In 1989 as the deterioration in the real estate market progressed, the trustees borrowed, using a letter of credit to get the cash to pay off the short-term debt. The president of the REIT said, ‘It was a prudent thing to do at the time.’¹⁵ Hoyt’s analysis suggested that there would be an extended downturn in real estate values following a stock market crash. After prolonged agony, the REIT crashed.

The story of the collapse of the bubble in the Japanese real estate market in the 1990s begins in the early 1950s when GDP began to increase rapidly in both nominal and real terms from the sharply depressed values immediately after World War II. (Japanese per capita income returned to the 1940 level in 1951.) Exports increased rapidly, and the composition of exports shifted from cheap toys and textiles to bicycles and motorcycles and then to steel and automobiles and electronics. The government began to deregulate financial controls during the first half of the 1980s, and extensive efforts by the Bank of Japan to limit the appreciation of the yen in the second half of the 1980s led to rapid growth in the supplies of money and of credit.

Real estate prices increased steadily, although with substantial year-on-year variability. Because of financial regulation, the nominal interest had been below the inflation rates in the 1950s, the 1960s, and the 1970s; the real rate of return on bank deposits and other fixed price assets often was negative. The price index for residential real estate in six large cities started at 100 in 1955 and reached 4100 in the mid-1970s and 5800 in 1980; the owners of real estate were one of the few groups with a positive real rate of return. During the 1980s the price of real estate increased by a factor of five to six.¹⁶ At its peak, the value of real estate in Japan was twice the value of real estate in the United States; and the ratio of the value of real estate to GDP in Japan was four times higher.¹⁷

The Nikkei stock market index, which started at 100 in May 1949, reached 6000 by the early 1980s. Stock prices surged in the second half of the 1980s and nearly reached 40,000 at the end of 1989. The volume of shares traded did not quite keep pace, going from 120 billion shares in 1983 to 280 billion in 1989.¹⁸

The increase in the real estate prices fed the boom in stock prices. Many of the firms listed on the Tokyo Stock Exchange were real estate companies that owned substantial property in central Tokyo and Osaka and Nagoya and a few other major cities. The boom in real estate prices and financial deregulation led to a surge in construction activity. Banks owned large amounts of real estate and stocks so increases in their values led to increases in the value of bank stocks. Banks usually required that borrowers pledge real estate as collateral; the increases in the value of real estate meant that the value of the collateral increased, and the banks were eager to make more loans because they wanted to increase their size – their total footings – relative to other Japanese banks and to banks in the United States and Europe. Industrial firms were increasingly eager to borrow to buy real estate, since the profit rate on real estate investments was many times higher than the profit rates from producing steel and automobiles and TVs.

The rapid expansion of bank loans was facilitated by financial deregulation, which was partly a response to pressure from the US government. Officials in the US were motivated by the unevenness of the regulatory framework, since US firms found many regulations impeded their expansion in the Tokyo markets while Japanese firms found it much easier to expand in the United States. Moreover the US Treasury wanted Japanese financial institutions to buy US government securities as the US fiscal deficit increased.

Deregulation proceeded slowly and deliberately.¹⁹ The deregulation of interest rates paid by banks on large deposits was staggered, with the minimum reduced by steps from ¥1 billion (for terms of three months to two years) to ¥500 million and ¥300 million in 1986, ¥100 million (and one month) in 1987, ¥50 million and then ¥30 million in 1988, and ¥10 million in 1989.²⁰ In the early stages of this process, the Bank of Japan reduced its discount rate from 5.5 percent in 1982 to 5 percent in 1983, 3.5 percent at the beginning of 1986 and 2.5 percent a year later. The 1986 reduction was taken simultaneously – with similar action by the Federal Reserve and the Bundesbank. In reverse, however, first the United States in the middle of 1987 and Germany in 1988 began increasing interest rates. The Bank of Japan waited until a new governor, Yasuki Mieno, took over in December 1989, and then restricted increases in credit for real estate. The crash began in January 1990 and became more intense when it became known that some major banks had made good losses on loans to favored customers and hidden these transactions by imaginative accounting.²¹

The euphoria in Japan was evident in many ways. There was a boom in corporate investments in plant and equipment. The vision in Herman Kahn’s The Emerging Japanese Superstate: Challenge and Response, published in 1970, appeared to be becoming reality.²² Japanese firms were preparing for a glorious global future. A construction boom followed: there was a real estate construction boom; several hundred new golf courses were built. A new office block next to the Tokyo railroad station was named ‘The Pacific Century Building’.

Stock prices peaked on the last trading day of 1989 and declined by 30 percent in 1990. The trough for stock prices occurred in 2002 at a level that was a bit more than 20 percent of their peak values. Real estate prices fell more slowly but almost as extensively.

The result of the decline in asset values was that many financial institutions were de-capitalized and remained in business only because of the implicit support of the government. A few were allowed (or forced) to close, although no depositor incurred a loss. The banks became owners of thousands of French paintings. Several hundred golf courses went bankrupt.

Economic growth plummeted. The inflation rate began to fall and then ten years later the price level began to fall. There was no way to recover the gold leaf that had been sprinkled on the desserts. The failures of firms meant that the banks took over title to the properties and sold them, which put further downward pressure on property prices which complicated the business plans of other firms. There was a downward spiral and concern about a debt deflation trap.²³ Commercial and industrial enterprises were going bankrupt at a steady rate of 1000 a month. Three large credit unions were rescued by the government. The capital adequacy problems of the banks and insurance companies were compounded by losses on their portfolios of foreign assets. Two economic experts on Japan have characterized the country’s problems for the next decade as ‘debt, deflation, default, demography and deregulation’.²⁴

Commodity prices, asset prices, and monetary policy

The reduction in the Bank of Japan’s discount rate, especially after 1986, which touched off the bubble, was stimulated by pressures from the United States and other industrialized countries and rationalized because the price level in Japan was steady. The appreciation of the yen from 240 to the US dollar in 1985 to 130 in 1988 led to downward pressure on prices of goods and services.²⁵

A major question is whether central bankers should be concerned with asset prices. Most central bankers choose stability of the goods price level as the target of monetary policy,²⁶ whether it be wholesale prices, the consumer price index, or the gross domestic product deflator is not a critical issue. Most recently the policy mantra has been inflation targeting – central banks aim to achieve an inflation rate no higher than 2 percent. If, however, the implosion of a bubble in stocks and/or real estate leads to a significant decline in bank solvency, should the central banks be concerned with asset prices? In one view, asset prices should be incorporated into the general price level because, in a world of efficient markets, they forecast future prices and consumption.²⁷ But this view assumes that asset prices are determined by the economic fundamentals and are not affected by the herd behavior that leads to a bubble.

Central bankers traditionally have not been reluctant to raise interest rates to prevent an increase in the inflation rate. They are exceedingly reluctant to deal with asset price bubbles or even to recognize that they exist or could have existed – although after 2008 they are well recognized. The decline of 40 percent in US stock prices from 2000 to 2003 is evidence that there had been a bubble in stocks. Similarly the decline of 30 percent in the price of US residential real estate between 2006 and 2010 indicates that there had been a bubble in property prices, which had been especially sharp in Arizona, Florida, and California. One question is why those outside the Federal Reserve found it easier to recognize that the increase in asset prices in both episodes was non-sustainable. And in that sense the much younger Federal Reserve of the 1920s seems more heroic in its statements about asset price developments.