What is speculative bubble?“A (speculative) bubble is a continuing growth in the price of an asset that cannot be justified by its fundamental value” (Hoshi and Kashyap, 2001) usually upon expectation of the rise of the asset priceA speculative bubble ended with collapse of the asset price, such as stock and/or real estate. Then agencies with high leveraged balance sheet suffer from the risk of default. By he reversed wealth effect decrease consumption by household and investment by corporate, worsening real economy.So, precautionary action from government is needed in advance, and the action should not be too much.Individuals should worry about the bubble and prevent from burst. Checking their risk-return profile of the portfolio and decreasing leverage is needed, when there is alarm that there might be a bubble.Examples bubble in historyThere are many samples of bubbles & crisis in economic history, these are the Dutch Tulip mania, the South Sea bubble in England, the Mississippi bubble in France, Railway mania in the United Kingdom, the Great Crash of 1929 in the United States.Recently in 1980s and 1990s, there are Japan, Norway, Finland, Sweden, Argentina, Chile, Indonesia, Mexico, Malaysia, Indonesia, Thailand, and South Korea. (Allen and Gale, 2000)More recently in 2000s, dot-com Bubble mainly in the United States, but it affected many developed and developing economies simultaneously.Most recent case is mortgage bubble and burst in the United States in 2007, it is still underway.The Japanese bubble and burst is occurred in 1980s and 1990s. The 1990s recession is called ‘Lost Decade’, because the Japanese crisis last over a decade. Financial liberalization was one of the causes that made economic bubble in Japan. Deregulation affected in five sectors. First, bond market liberalization. An Unsecured bond issuance was allowed fully by the government in January 1, 1966. Second, new financial product such as the certificate of deposit (CDs), commercial paper (CP), and warrant bonds were introduced. Third, Internationalization. Fourth, interest rate control. Fifth, stock market regulation.Late 1980s, especially from 1985 to 1989, stock price increased dramatically and so the price of real estate. Nikkei 225 index was increased from 10,000 in 1985, to 38,916 in 1989. The rate of return of stock in Japan exceeded the rate of nominal GDP for 7 years. Japanese government raised interest rate to block inflation, resulting in a burst of bubble in 1990. The Nikkei 225 index dropped to 20,222 by October 1,1990. The real estate price also collapsed.During the Japanese bubble, inflation rate was stable and government can go on low interest rate policy. Household increased the proportion of stock and real estate among their total asset. Non-financial Corporate financed with low cost from CP, warrants in the overseas and invested in real estate.Because of deregulation of finance, main bank governance for the borrower became weak. Banks increased lending to the households and small companies for make a new customer as a substitute of a big corporate. Last phase of bubble, investment for foreign stock and real estate was increased.The tax law related to real estate, such as low holding tax, high selling tax, exacerbated the bubble.After burst, the price of real estate decreased for 11 years in a row from 1992. Long term recession caused more serious problem, such as deflation, almost 0% of potential growth rate due to the long low investment, transferring of default from small company to large company.Long term low interest rate also showed demerit, such as low level of consumption due to the low interest rate return, low return of corporate pension, postponing of restructuring corporate due to the low cost of capital.One of the factors that made such a long recession, a lost decade, is that reaction from government authority was not big enough, fast enough.Norway, Finland and Sweden also underwent similar bubble process, in similar years. In Norway, lending increased by 40% in 1985 and 1986. In Finland, an expansionary policy in 1987 caused massive credit expansion. In Sweden, a steady credit expansion through the late 1980s was the genesis of the bubble.As an emerging country, Mexico experienced similar bubble. In this case, banks were privatized and financial liberalization occurred in early 1990s. Bank credit to private nonfinancial corporation was 40% of GDP in 1994. And assets collapse, banking and foreign exchange crisis happen followed by a severe recession.A credit expansion was in common cause of a bubble. But the triggers of burst are different from country to country.How the bubble might arise.Bubbles usually have three distinctive phases. (Allen and Gale, 2000)1. Financial liberalization or action by central bank to increase lending. The credit expansion causes a rise of asset price, such as stocks or real estate. The bubble inflates a few years or so, until it bursts.2. The bubble bursts and the price of asset decrease dramatically, usually in a short time, but sometimes in a long time.3. Default of many firms and the agents which have leveraged investment is followed by bubble burst. Banking crisis arise a year later on average after burst. And foreign exchange problem may ensue. These problems can cause a crisis on real economy. Then, recession lasts for a year and a half on average.In phase 1, risk shifting does a major role. An investor who can borrow money from banks, can earn all the benefits from asset investment, but do not need to take all risk. Because when the investment’s earning is not enough to pay for the interest of borrowing, investor can default.So, risk shifting has a possibility of asset bubble. Technically speaking, the price of asset, when there is risk shifting, can be over the fundamental price, which is the discounted value of expected future payoffs.The risk shifting problem is resulted from the inability of lenders to observe the risk of borrower’s investmentIn phase 2, expectation of credit expansion is the key factor of burst. When a credit expansion does not catch up with investor’s expectation of credit expansion, asset price starts to collapse.Is it a speculative bubble in Japan during 1980s?Stone and Ziemba’s perspectiveWe can decide it is speculative bubble when the price of the asset can not be explained by economic fundamentals.In the case of Japanese asset rise in 1980s, some part of it is speculative and the others are not. Especially speculative land, for example golf course membership, is speculative bubble, because it is traded for expectation of future price rise. But, other prices of stocks and land can be explained by economic fundamental changes, such as interest rates and credit market conditions.In the late 1991, the total land value in Japan was nearly $20trillion. This was about double the world’s equity markets of half the world’s bond markets. In December 1989, the Japanese stock market valuation was $4trillion, which was about 44 percent of the world’s equity market. (Stone and Ziemba, 1993)These huge valuations of the land and stock in Japan at its peak show that, in a sense, Japanese economy is bubble economy, if it is not explained by the fundamental factors.Japan’s relatively high price of land is explained by the factors like population density, land utilization, regulations restricting land use, property tax laws encouraging the holding of land, agricultural protection, etc.In terms of density, Japan’s population per unit of habitable area is about 30 times that of the United States. And Japan’s GDP per unit of habitable land is about 21 times as large. (Stone and Ziemba, 1993)The use of land in Japan is strictly restricted by law. These are low tax for holding land, high tax for selling land and low valuation for inherited land for tax purpose.Utilization of the land is also not enough, because of regulation on zoning, height restrictions, etc. Land owners hold vacant land or turn the land into parking lots. Utilization problem is crucial in Japan. Especially in Tokyo, 160,000 acres are available for hosingTokyo’s high land price can be explained by in efficiencies and excess concentration in that area. And another rational reason of high price of land is that tax rate for agricultural land is less than a tenth as heavily as urban land.A low Japanese time preference is another factor for high land price, with high savings despite low interest rates.As a result, Japan’s land price is explainable by the economic factors. And Japanese government has the tool to lower the price of land, such as tax and regulatory instrument.When it comes to Japan’s stock price, the stock price of Japan goes with land price in tandem. The correlation between land price and stock price in Japan was over 99 percent in biannual series up to 1988. Generally, stock price leads land price with a lag of about a year in Japan. This relationship between stock price and land price is not the case in the United States.However, the volatility of the land price and that of stock price is quite different. That of stock is much more volatile.The reason why the price of stock is highly correlated with the price of land is that Japanese usually borrowed money with stock as collateral to invest in land, vice versa.Many literatures about the price of stock and land are argued explainable by the fundamental factor.Interest rate in late 1980s and early 1990s shows how fundamental factors affected stock price and land price. In 1985-86, interest rate was dramatically lowered with sharp rise in stock/land price. In 1987-89, the rate stayed low, and stock/land price rose still. In 1989-90, interest rate increase from 2.5% to over 6.0% with the collapse of stock/land price.There is evidence of speculative bubble. It is one thing such as using one asset as collateral to buy the other. In this process, there comes up leverage. The leverage makes over pricing. It goes to bubble.Another evidence is that stock prices overestimated since 1983. “The extreme increase in stock prices in the 1980s occurred during a period of declining required risk premiums in relation to rates of return” Ueda(1990). It means there were speculative trade based on expectation of future price increase.Study of distribution of golf course membership prices are resulted in very fat tail relative to the price of stock in the United States. It also means that there was speculative bubble.Old habit of cross share holding is another factor for speculative bubble to extend or continue. Because Japanese company purchase each other’s share for the purpose of affirming group membership, protecting the other company from take over threat, cementing business relationship. These reasons are not fundamental reason to buy stocks, so the price of stock might be different from its fundamental value.Allen and Gale’s perspectiveAllen and Gale(2000) made a formal model, equation, to explain the possibility of speculative bubble, in the assumption, which is acceptable for the bubble and crisis in Japan, including Scandinavia, South East Asia, Mexico, and other emerging countries.According to their argument, the possibility of borrowing for the financial investment is a crucial element of the bubble.Borrower can default, if return is not enough to pay for loan. So, the risk is shifted from investor to creditor banks. This risk shifting can cause the possibility of pricing up above its fundamental value.Allen and Gale(2000) argued expectations that future credit expansion may slow down can cause an end to a bubble.The pricing model by Allen and Gale(2000) says that the equilibrium price with borrowing can be higher or at least the same to the fundamental price without borrowingIt can be expressed as follows, when using equation.Allen and Gale(2000) assumed weak monitoring from creditor bank for the risk of the borrower’s investment. It is acceptable in Japan’s bubble case.In 1980s, the competition of bank lending and deregulation policy made financial intermediaries to weaken their monitoring ability.Final RemarksThe definition of speculative bubble itself is a little vague. So, distinction between sharp rise in stock price with full fundamental explanation and mild rise without fundamental factors is quite difficult matter.For example, if the price of asset increased 100% in a year without speculation, what can we call the phenomenon like this? Even though speculation is usually main factor of shape rise of asset price in a real world, it can not be an absolute principle.In this paper, one aspect of causes of bubble is skipped. This is psychological factors. Recently, many attempts to understand economic phenomenon by psychological aspects appears.The speculative bubble problem can be explained by psychological factors, such as greed, irrationality, herding behavior, etc.But these factors usually do the role of deepening a bubble, not originating it.Considering Japanese bubble and ‘a lost decade’, the best answer for the bubble is precautious action from the government not to emerge it.ReferencesAllen, Franklin and Douglas Gale (2000) ‘Bubbles and Crises’, in The Economic Journal, Volume 110, January, pp236-55Choi, HeeGap (2003), ‘The lesson from Japanese bubble economy’, in Issue Paper May 24th, 2003, Samsung Economic Research Institute.Hoshi,Takeo and Anil Kashyap (2001), Corporate Financing and Governance in Japan : the road to the future, The MIT Press,Stone, Douglas and William Ziemba (1993) ‘Land and Stock Prices in Japan’, in Journal of Economic Perspectives, Volume 7 Number 3, Summer, pp149-65Ueda, Kazuo (1990) ‘Are Japanese Stock Prices Too High?’ in Journal of the Japanese and International Economics, December 1990