FINANCIAL SECTOR LEARNING PROGRAM

DISCUSSION ABSTRACT NO. 2

Proceedings from the World Bank and Federal Reserve Bank of Chicago conference on

Asset Price Bubbles

Implications for Monetary, Regulatory, and International Policies
April 2425, 2002 Chicago, Illinois

This work is copied with permission from the introduction to Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies, edited by William Hunter, George Kaufman, and Michael Pomerleano, and published by MIT Press in 2003. To learn more about the conference, please contact Ms. Colleen Mascenik, Financial Sector, World Bank, at +1-202-473-7734, via fax at +1-202-522-7105, or via email at cmascenik@worldbank.org.

Contents

Preface ................................................................................................iii

Overview ..............................................................................................1

Contributors........................................................................................19

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Preface

A DISTINCTIVE FEATURE OF THE LAST TWO decades has been the prolonged buildups and sharp collapses in asset markets in the industrialized and developing world. In this context, the World Bank Group and the Federal Reserve Bank of Chicago cosponsored a conference on Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies, the fourth in a series of international conferences on current policy challenges facing domestic and international policymakers. The conference was held at the Federal Reserve Bank of Chicago in Chicago, Illinois, from April 2425, 2002. The conference explored evidence on the causes and implications of asset price bubbles and discussed the potential role of central banks and prudential regulatory agencies in preventing financial instability. Some of the key topics that were addressed include: recent experiences with asset price bubbles; implications of bubbles for monetary and prudential regulatory policy; and policies for protecting against bubbles.

Participants and contributors included internationally recognized experts from official institutions, the private sector, and academia. The organizers of the conference were: William C. Hunter, Senior Vice President and Director of Research, Economic Research Department, Federal Reserve Bank of Chicago, George G. Kaufman, Professor, School of Business Administration, Loyola University, and Michael Pomerleano, Lead Financial Specialist, Financial Sector Development Department, The World Bank. The full proceedings of the conference were published by MIT Press in January 2003. The volume is titled Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies. It can be purchased at http://mitpress.mit.edu/.

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Overview
Edited by William C. Hunter, George G. Kaufman, and Michael Pomerleano

The Context As is well known, not all financial crises are the same. Crises in developing countries tend to be more protracted and more costly as a percentage of gross domestic product (GDP) than crises in developed countries. For instance, while in the United States the costs of cleaning up savings and loan institutions amounted to $180 billion, or 3 percent of GDP, in Sweden in 1991 the bank recapitalization costs totaled 4 percent of GDP; in Thailand the net losses are estimated at $60 billion, or 42 percent of GDP, from 1997 to present; and in Indonesia the fiscal costs are estimated at 55 percent of GDP from 1997 to present. The varied experiences that emerging and developed economies have had with financial crises in recent history have highlighted the importance of good macroeconomic, financial, and regulatory policies. The recent volatility of asset price markets has sparked an intense debate in

academic and policy circles regarding the appropriate monetary and regulatory response to these dramatic shifts. Although the large gains and losses associated with asset bubbles have been well documented, surprisingly little consensus exists about the causes, characteristics, and behavior of asset bubbles. For this reason, the editors organized the conference, Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies, in an attempt to fill this void. As Robert J. Shiller notes in his keynote address, researchers of various intellectual backgrounds have approached the bubbles question without agreement: Microeconomists still rarely cite macroeconomists, economists rarely site psychologists, and academics rarely site news media stories. As a result, the conclusions of this research are fragmentaryeach observers analysis resembles the parable of blind men who are asked to describe an elephant by touching one part.

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In the past two years, economies around the world are experiencing the financial distress brought about by excessesthe sharp run-up in debt and equity investments in high-tech, telecommunications, and other firms, including the failed energy trader Enron and struggling telecom WorldCom during the late 1990s bubble. Robert Shiller attributes the rapid rise of the U.S. stock market to optimism about the advent of the World Wide Web, to Western market economy triumphalism over other economic regimes, to capital gains tax cuts and the rise of pension plans such as 401(K) plans, to the lowering of transaction costs, and to the expanding volume of stock trades, among other factors. Similar exuberance prevailed in East Asia prior to 1997. The asset price bubble was amplified by the confidence expressed in the East Asian miracle as a paradigm for sustained economic growth. In both cases, the bubbles were followed by increases in market risk premiums, tightening of credit standards and availability, and a fall in stock market and other asset prices. Despite the similarities, the severity of the post-bubble losses and the potential for spillover into the real economy have varied. In Asset Prices Bubbles, Information, and Public Policy, Randall S. Kroszner observes that asset bubbles are not a new phenomenon of the 1990s; witness the Dutch tulip mania in the seventeenth century and the South Sea bubble in the eighteenth century.

However, the succession of asset price bubbles in the past two decades, coupled with faster and larger movements of capital and information across borders, fixed currency regimes, and weak banking systems in some countries, has created a serious policy challenge. Asset prices inflated and then collapsed, leading to crises first in Japan, subsequently in East Asiaparticularly Thailand, and Malaysiaand more recently in the United States. The macroeconomic losses were often substantial, as a database of financial crises indicates, resulting in fiscal costs, slower growth, and social costs, such as higher unemployment and poorer public health.1 In addition to these measurable losses, economies faced the opportunity costs in terms of development. Allan H. Meltzer, in Rational and Nonrational Bubbles, notes that theoretical general equilibrium models give no support to proposals urging policymakers to respond to asset price changes. The economics profession is not close to having a useful model of asset prices that separates the various sources of change. Furthermore, examinations of bubble episodes do not offer a consistent explanation of the behavior of buyers and sellers. He raises one policy lesson that has been reinforced by recent experience: Asset price declines, even large declines, need not be followed by output price deflation or by deep and lasting recessions. The U.S. stock market decline in 1987 and the NASDAQ decline in 2000 were not the

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prelude to major recessions or deflations, as in the United States in the 1930s or Japan in the 1990s. The difference is explained mainly by the decisions regarding policy actions. This experience suggests that expansive economic policies can compensate for any deflationary impact that asset prices have on output prices. Jean-Claude Trichet raises the issue of the proper role of the central bank in his contribution, Asset Price Bubbles and Their Implications for Monetary Policy and Financial Stability. He notes that asset price developments are a serious cause of concern for central banks since they may affect price and financial stability. However, he expresses the view central banks should not introduce asset prices into their monetary policy reaction function. He advances two reasons: First, it is difficult to implement a sound monetary policy while focusing on highly volatile indicators; second, he doubts that asset prices can be determined scientifically. Trichet also emphasizes that measures aimed at improving market transparency and reducing herding behavior can improve the functioning of the financial system. The recommendations focused on regulatory, accounting measures, tax rules and regulations, as well as of codes of good conduct and good practices. In Asset Prices and Monetary Policy, Michael Mussa echoes concerns about monetary policy. He observes that adjustments in monetary policy have

broad effects on financial markets and the economy. Monetary policy is a blunt instrument for responding to a narrow class of asset markets. Therefore, the suppression of most asset price volatility through monetary policy is neither feasible nor desirable. He concludes that it is not practical to think of linking adjustments in monetary policy in some mechanical way to movements in asset prices. Further, he is skeptical about rational bubbles. However, his central thesis is that, beyond their general relevance as macroeconomic indicators, in exceptional times and circumstances, asset prices should exert a special influence on the conduct of monetary policy. By unraveling the factors that lead to and amplify asset bubbles, the papers presented during the conference help to explain why some bubbles result in greater, more prolonged losses and what policymakers can do to safeguard economies from these costly, destabilizing episodes. This book attempts to synthesize the various strands of analysis to offer policymakers a more complete picture of what asset price bubbles are, how we might identify them, andmost importantlywhat we should do to avoid or limit the destructive havoc they may inflict on the financial system and economy. Recent Experience with Asset Price Bubbles Various regional experiences provide historical perspectives on how asset price bubbles develop and the kinds of policy

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environments that tend to exaggerate or mitigate the impact of collapses. In U.S. Stock Market Crashes and Their Aftermath: Implications for Monetary Policy, Frederic S. Mishkin and Eugene N. White examine fifteen episodes of stock market crashes in the United States throughout the twentieth century and classify them by the extent of their impact on the rest of the financial system. Their findings corroborate the general consensus that bubbles are very difficult to identify ex ante. They argue that the U.S. Federal Reserve System does not have an informational advantage over investors and therefore is unlikely to recognize a developing bubble or to prick it in advance. Further, in their view, the link between monetary policy actions and stock prices is tenuous at best. Therefore, attempts to prevent bubbles through monetary policy might not be so critical. Mishkin and Whites data indicate that in the history of U.S. stock crashes many stock market bubbles have burst (for example, in 1946, 1962, and 2000) without causing financial instability. This has been especially true in cases where bank balance sheets and the financial system were sound before the onset of crashes. The authors conclude that the critical question facing monetary policymakers is not whether a stock market crash is coming or can be prevented, but whether financial instability is present. Central banks are therefore advised to focus their policy responses on financial regulatory meas-

ures that ensure the robustness of banking systems. Although very different, Japans experience with a bursting asset price bubble in the late 1980s illustrates some of the same conclusions. In Japans Experience with Asset Price Bubbles: Is It a Case for Inflation Targeting?, Kunio Okina and Shigenori Shiratsuka examine the Bank of Japans policies in the late 1980s, when an asset price collapse initiated an economic downturn that has lasted more than a decade. They examine the common criticisms of Japanese monetary policy: excessive monetary easing in the late 1980s and a delayed policy reversal toward monetary tightening. Okina and Shiratsuka also recognize the challenge that policymakers face in identifying bubbles. In particular, various macroeconomic models for assessing Japans inflation and output gap in the late 1980s suggest conflicting policy responses depending upon assumptions and modeling choices. Key among these choices are how to decompose the rising growth rate into cyclical and trend components, how to evaluate inflationary pressures and the fundamental value of asset prices, and how to identify the correct path for potential growth. The authors conclude that assets do not provide sufficient information for making real-time judgments about future growth, that the potential for flexible interest rate targeting is therefore limited, and that

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other guideposts are necessary for monetary policymaking. Unlike the recent experience in the United States, the bursting of the Japanese asset bubble led to a longterm economic slowdown. Financial system vulnerabilities amplified the adverse impact of the bubble collapse. Banks continued to lend to unprofitable firms in an effort to prevent losses from materializing (evergreen lending). At the same time, the losses eroded the capital of the banks, reducing the capacity of financial institutions to take risks, leading to a credit crunch. As a result, the easing of monetary policy was not effective, and the effectiveness of monetary policy was hindered by the lack of new lending. Waves of optimism, in the words of Charles Collyns and Abdelhak Senhadji in Lending Booms, Real Estate Bubbles, and the Asian Crisis, led to large capital inflows in many East Asian countries, a fast-paced expansion of domestic credit by an underregulated banking system, and high rates of investment in the property sector. The subsequent outflows of capital were followed by extreme pessimism, investor flight, bank failures, and collapsing equity, housing, and debt markets. Often, the impact was not limited to the financial markets. East Asias financial crisis quickly deteriorated into an economic and social crisis. Real wages plummeted, and the regions major cities filled with workers seeking jobs. In the coun-

tryside, rural credit evaporated and threatened the livelihood of many. In East Asia prior to the 1997 crisis, Collyns and Senhadji find a strong link between the underestimation of risk, a wave of optimism, and lending booms, especially in the real estate sector, on the one hand, and the asset price inflation that followed, on the other. The real estate sector provided a dramatic illustration of this cycle, because property values rose at an accelerating pace, while banks that lent out on the basis of collateral value showed increasing willingness and capacity to lend. Collyns and Senhadji describe an asymmetric response of property prices to credit, whereby the response during periods of rising property prices is three times the response during periods of declining prices. They attribute this asymmetry in large part to opaque real estate markets. When the bubbles burst in East Asia, the outcomes were varied. Collyns and Senhadji emphasize that the extreme property price cycles were neither necessary nor sufficient to cause the subsequent crises that struck some of the countries exchange markets and banks. For instance, Hong Kong SAR, Malaysia, and Singapore survived the real estate fallout and minimized damage to the rest of their economies. It is no coincidence that these economies had relatively strong banking regulatory frameworks before the bubbles formed and policymakers took immediate action to reduce and contain the disruptive impact when the bubbles burst. This

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experience again underscores the importance of sound banking regulation to buffer a financial system from severe losses after the collapse of a bubble. In Tropical Bubbles: Asset Prices in Latin America, 19802001, Santiago Herrera and Guillermo E. Perry document similar problems in Latin America. Bubbles in asset price markets deserve policymakers attention, because they often precede sharp and costly crashes in financial markets, with potentially broader consequences. Perry and Herrera calculate that between 1980 and 2000 fourteen of the twenty-two episodes of asset price bubbles in Latin America ended in crashes. Further, these crashes tended to produce currency crises in the region. Perry and Herrera document Latin Americas experiences with the rise and collapse of asset price bubbles since 1980 and identify a set of common determinants. Domestic factors include rapid credit expansion and the volatility of credit growth and asset returns. External factors include changes in capital flows as a result of changes in short-term interest rates in the United States. Asset price bubbles can, in part, be attributed to wealth effects in household consumptionrising perceptions about the future growth of incomes, increasing creditworthiness of households, and changes in corporate investment as a result of falling cost of new capital, rising expectations about future growth of earnings, and greater perceived creditworthiness of firms. Based on twenty-

one years of evidence from Latin America, Perry and Herrera conclude that it would be extremely risky to predict or preemptively attempt to burst asset bubbles. Instead, they suggest that policymakers should focus on country-specific domestic factors to buffer against bubbles and mitigate their impact. Such measures include smoothing the cyclical behavior of credit for the private sector, restricting the use of stocks and real estate as loan collateral during booms, raising capital requirements for highly leveraged banks, imposing ceilings on credit growth, and, over the longer term, promoting the development of secondary markets, real estate investment trusts, and other market instruments for spreading risks. The collective experiences of many countries suggest that policymakers face similar challenges around the world. First, bubbles are difficult to identify ex ante. There is always the possibility that asset appreciation reflects a favorable change in economic fundamentals. However, monetary policymakers possess incomplete and often ambiguous ex ante information in making that determination and are also subject to public and political pressures. Even countries with highly sophisticated supervisory institutions and central banks with extensive, highly transparent information resources have had difficulty identifying bubbles. Second, for the most part, bubbles have followed the rapid expansion of credit. Third, the collapse of bubbles has produced various

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outcomes in different countries, with robust financial systems showing less systemic distress than weak systems. Fourth, advanced economic development does not make an economy immune to an asset price collapse. Finally, as these experiences warn, attempts to prick a bubble may backfire: Intervention may cause more harm than good. What, then, should be the role of policy based on these experiences? In general, the collective works suggest that policymakers should strengthen regulatory and prudential policy. Because credit booms often give way to asset price bubbles, many of the authors suggest measures to contain rapid credit growth (such as higher collateral coverage), improved credit practices, and less reliance on stocks and real estate collateral as the basis for lending. Other authors suggest emphasizing contracyclical loan-loss provisioning during boom times. Theory and History of Asset Price Bubbles To provide a theoretical framework for understanding the causes and policy implications of asset price bubbles, various authors have proposed models to explain why these bubbles form. In Stocks as Money: Convenience Yield and the Tech-Stock Bubble, John H. Cochrane analyzes price movements of U.S. technology stocks in the 1990s and advances the model of Rational Behavior with Friction. He suggests

that some stock prices vary based on a convenience yield that has to do with the availability of information and the velocity of trading. That is, the recent demand for tech stocks, despite their prices being well above the fundamentals, represented something similar to a demand for cash as opposed to irrational beliefs about future stock prices. Just as people hold paper money for short periods of time for its usefulness in making transactions, people would buy shares of a given stock, say Palm, in order to make future transactions with it. Because of the inability to sell short costlessly, betting one way or the other on the future of a company requires owning its stock. Palms share outstanding were very limited, giving it the convenience yield. Once the amount of shares outstanding increased significantly, the transaction value diminished, causing the share price to fall. In Bubble Psychology, Werner De Bondt approaches the same question from the perspective of behavioral and finance psychology to assess the motivations that drive the behavior of individual investors. Individuals derive knowledge, he argues, from experience, logic, and authority applied to mental frameworks that result in rather predictable patterns of behavior. For example, individual investors tend to place a premium on stocks that are glamorous or familiar; they also tend to manage risks poorly and lack adequate portfolio diversification, because their knowledge is narrow.

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In his commentary, Bertrand Renaud notes that behavioral models are very difficult to test empirically. Further, he points out that De Bondts model focuses on the individual investor, and he asks how valuable are behavioral analyses of individual investors in markets that are dominated by institutional investors, that have better information and possess professional skills and sophisticated riskmanagement methods. In their paper Bubbles in Real Estate Markets, Richard Herring and Susan Wachter point out that real estate prices behave differently from equity or other asset prices. They develop a model for explaining the unusually dramatic cycles in this market. The model describes a cycle that takes place in bank-dominated financial systems: rapid expansion of bank credit into the real estate sector, which in turn leads to increased value of real estate prices. Higher real estate prices increase the perceived collateral value of these assets to banks and, in turn, decrease the banks perception of risk in the real estate market. As such, banks are motivated to lend more to the real estate market, at greater risk and at lower cost to the borrowers. The authors offer several explanations as to why banks expose themselves to this increasing degree of risk: disaster myopia, perverse incentives (high leverage, implicit insurance, herd behavior, principalagent conflicts), short-term players, poor data, and inadequate analysis.

The policy implications of these three models suggest several courses of action to address the problem of potentially destabilizing asset price cycles. The models of Cochrane and De Bondt suggest that a key role of policymakers is to improve the quality and quantity of information and transparency in order to minimize information gaps. Their models also suggest that boom and bust cycles are not easily identified ex ante. Herring and Wachters model suggests that monetary policymakers should not expand credit too rapidly and that financial regulatory policies should take an active role in restricting the potentially hazardous, seemingly irrational, risk taking in real estate markets. Empirical Dimensions of Asset Price Bubbles Applying theoretical models to asset price bubbles draws attention to the critical questions facing financial policymakers: What information is available regarding bubbles? What information is relevant? And what, if anything, should be done about it? Policymakers must make selective use of a large set of conflicting information and imprecise indicators. Moreover, they have to make decisions in real time regarding prospective economic growth and prices, without the benefit of hindsight. In Imbalances or Bubbles? Implications for Monetary and Financial Stability, Claudio Borio and Philip Lowe examine the annual movements of asset prices in thirty-four countries beginning

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in 1962, looking at thirty-eight crisis episodes. To replicate the perspective of a monetary policymaker, the authors select only data that were available ex ante; they examine the asset price gap, credit gap, and investment gap. Working from data that shows two completed asset price cycles since the 1970s, Borio and Lowe arrive at two key observations: 1) credit and asset price cycles often proceed in tandem, and 2) cycles appear to be increasing in magnitude. Based on this analysis, they conclude that asset price information is useful and that central banks should use individual and aggregate asset prices as a tool for conducting monetary policy. In A Stochastic Index of the Cost of Life: An Application to Recent and Historical Asset Price Fluctuations, Michael F. Bryan, Stephen G. Cecchetti, and Risn OSullivan agree that asset prices offer useful information for monetary policymakers but eschew measures that focus only on the current cost of current consumption. This perspective, they argue, creates an inter-temporal substitution bias and should be revised to capture the current cost of future consumption. To correct this bias, the authors create a cost of life index. Applying dynamic factor methodology, they use asset prices to measure the flow of future services and combine this with the cost of current consumption in a weighted average. Bryan, Cecchetti, and OSullivans work has important messages: It underscores the importance of inter-temporal analy-

sis, it warns against relying too heavily on current consumer price index prices, and it highlights the challenge of capturing the changing prices of nonfinancial assets. Unfortunately, there are no clearly marked road signs identifying asset bubbles. Hence, for every suggestion, there are qualifiers. Bryan, Cecchetti, and OSullivan warn that price information does not consistently tell the same story; during periods of real interest rate fluctuations, the information may be biased. Ellen R. McGrattan and Edward C. Prescott, in Testing for Stock Market Overvaluation/Undervaluation, develop a measure of capital stock and compare it to market capitalization to determine the presence of a bubble. By this measure, the authors conclude that the stock market was undervalued in 1929 and that there was no asset bubble. The subsequent crash was caused by severe tightening by the Fed, not the bursting of a bubble. Implications of Bubbles for Monetary Policy There is general consensus that asset prices offer at least some information that might be useful for monetary policymakers in the short term, but there are mixed views on whether asset prices have any significant relationship to output gaps and commodity inflation forecaststhe primary indicators for monetary policymakers. Therefore, the most important question is whether monetary policy should target asset prices.

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In Asset Prices in a Flexible Inflation Targeting Framework, Stephen G. Cecchetti, Hans Genberg, and Sushil Wadhwani argue that central bank action may be effective in certain circumstances in affecting asset prices. However, it is very difficult to apply, and yet should not be ruled out. Cecchetti, Genberg, and Wadhwani argue that a buildup of asset price misalignments can lead to macroeconomic imbalances, misaligned exchange rates, and lost competitiveness. When there are shocks in asset markets, a policy of leaning against the wind of asset price changes may balance outputs. Cecchetti, Genberg, and Wadhwani qualify their support for central bank action. Central bank responses to asset price misalignment yield beneficial results only in very limited circumstances. Macroeconomic performance has improved after policy has reacted modestly to asset price misalignments when these misalignments are due to financial shocks. However, policy responses have not been useful when productivity shocks or a change in fundamentals are the underlying determinants. Therefore, responding mechanically to all asset price changes can produce worse outcomes than not responding to any at all. Cecchetti, Genberg, and Wadhwani also note that several factors may constrain the effectiveness of monetary policy actionsfor example, the resiliency of the financial system, the openness of the economy, and the role of the banking sector.

In Interest Rate Policy Should Not React Directly to Asset Prices, Marvin Goodfriend takes the view that asset price fluctuations provide useful information. But in his opinion there should be no presumption of a correlation between asset price movements and real short-term interest rate movements; a relationship between these variables may be positive or negative. He argues that attempts to target asset prices may be counterproductive and that the downside risks of inappropriate action outweigh the potential benefits of useful intervention. His discussion of asset bubbles and monetary policy highlights several practical problems that constrain central banks. First, the information is not perfect. Markets do not capture all available information, central bank information is drawn from imperfect measurements, and contradictory signals can come from different asset prices such as exchange rates, housing prices, and stock values. Monetary policymakers cannot hope to identify and address all inflation and output misalignments. Second, as Goodfriend points out, there is a credibility issue: Central banks rely heavily on reputation and credibility, both of which are jeopardized by inappropriate, unnecessary, or poorly executed policy actions. Shocks are often too hard to identify as misalignments, which increases the risk of selecting the wrong policy and losing credibility. With weakened credibility, central banks are even less capable of performing their core functionmaintaining financial stability. In conclusion, he is skeptical about

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the usefulness of asset price information for influencing exchange rate or interest rate policy. In Comments on Implications of Bubbles for Monetary Policy, Benjamin M. Friedman is equally skeptical that univariate, mechanical extrapolations from asset prices are useful, given the risks of poor measurement and misinterpretation. Friedman captures the time constraint succinctly: What did they know? When did they know it? What could they do about it? Referring to the Central Bank of Japan in the late 1980s, Friedman notes that asset prices did not provide useful information in real time. International Transmission of Financial Shocks The challenge of responding to asset price bubbles is complicated by the fact that financial systems are increasingly interlinked across the world. By examining globalization in a historical context, Michael D. Bordo and Antu Panini Murshid, in Globalization and Changing Patterns in Crisis Transmission, offer observations and predictions about the frequency and direction of financial shocks. Their analysis draws on a comparison of two periods of rapid financial globalization, 18801914 and 19902002, to arrive at the following conclusions. First, there is strong evidence of global co-movement of asset prices in the 18801914 period and less evidence of such today, with patterns being more regional than

global. Second, there is less evidence of simultaneous shocks, but more evidence of shocks that are confined to groups of emerging or advanced countries. The probability of global crisis was lower in the most recent period than in the period from 1880 to 1914, but risks at the local and regional level were approximately the same in both periods. Unlike the earlier period of rapid globalization, when shocks generated in Western Europe extended to colonial territories, the shocks of recent periods tended to originate in emerging market countries and to spread within the immediate region. Philipp Hartmann, Stefan Straetmans, and Casper de Vries, in A Global Perspective on Extreme Currency Linkages, analyze currency markets over the past twenty years an find that the initial probability of a crisis occurring is higher in emerging markets than in developed economies. However, the analysis suggests that once a crisis has struck, the breadth of it is not more severe among emerging markets than among industrial countries. Todays economically advanced countries are more stable than before because they use better macroeconomic policies, are more transparent, have flexible exchange rate systems, and have reached a higher state of financial maturity and diversity of markets. In Asset Price Bubbles and Stock Market Interlinkages, Franklin Allen and Douglas Gale present a theoretical

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model based on an agency problem of the amount of credit provided for speculative investment. Their analysis recognizes that investors in real estate and stock markets borrow from banks. The authors analysis of bubbles and crises in capital markets emphasizes the agency conflict that exists between borrowers and lenders when information is asymmetric. Risk is shifted if the ultimate providers of fundsbanksare unable to analyze their investments due to the lack of financial sector expertise and resulting opacity. The shifting of risk increases the return to investment in the assets and causes investors to bid up asset prices above their fundamental value. In Banking Policy and Macroeconomic Stability: An Exploration, Gerard Caprio, Jr., and Patrick Honohan examine the banking sector and arrive at very similar conclusions. They emphasize the important role of deep financial markets and well-developed regulatory and supervisory institutions, which buffer countries from shocks in the financial system. The policy conclusions are that emerging market policymakers need to focus on strengthening macroeconomic policy, increasing transparency of information, and building up regulatory and supervisory capacity in order to avoid and mitigate the effects of financial shocks. Caprio and Honohan suggest that allowing foreign participation in the financial system is essential to achieving these goals. Greater reliance on foreign participation, when combined with

strong supervisory institutions and transparency, is seen as an important tool for insulating an economy from shocks. The authors qualify their recommendations with the warning that an effective regulatory environment with prompt corrective action may actually amplify shortterm shocks. Technology, the New Economy, and Asset Price Bubbles The United States witnessed rapid growth of its high-tech sector in the 1990s, especially the infamous dot.com and telecom firms that soared in a frenzy of investment with unlimited access to capital and then crashed. In retrospect, many observers have called this phenomenon a bubble, where tech stocks were extremely overvalued. According to Steven N. Kaplan, in Valuation and New Economy Firms, investors overestimated network effects and cost reductions and underestimated the effects of competition. The effects on the stock market are not clear, but some real effects are evident. Kaplan recognizes substantial improvements in productivity since 1990, as well as improvements in processes, many of which have come from outsourcing noncore labor functions, capital deepening, and a decline in transaction costs. Kaplan speculates that the U.S. economy will continue to reap these benefits over the next five to ten years. In Home Bias, Transaction Costs, and Prospects for the Euro, Catherine L. Mann and Ellen E. Meade point to a

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transformation of the intermediation process in asset markets: buying and selling as well as clearing and settlement that have had an effect on the allocation of international portfolios since 1990. Although intermediation and settlement costs have fallen, Mann and Meade find that information costs are still significant and remain the greatest transaction cost in international asset markets. As a result, they find that U.S. investors maintain a strong home bias. The implication is that foreign firms are well rewarded for listing in the U.S. securities markets and conforming to U.S. rules about information and disclosure. Implications for Prudential, Regulatory, and International Policies In light of the practical challenges in identifying and reacting appropriately to an asset price bubble with monetary policy, prudential policy offers possibly the best line of defense. Not only has historical analysis of bubbles and crashes linked frequency of crisis to weakness of regulatory policies, but economies have weathered the storm better when they have had strong supervisory and regulatory institutions. Reviewing recent financial crises, both Charles A. E. Goodhart, in The Historical Pattern of Economic Cycles and Their Interaction with Asset Prices and Financial Regulation, and Jeffrey Carmichael and Neil Esho, in Asset Price Bubbles and Prudential Regulation, note that financial regula-

tion tends to be inherently pro-cyclical. Both papers find that capital adequacy and provisioning rules have not anticipated or responded adequately to boombust cycles. Capital adequacy has been inappropriately low or not sufficiently responsive to cyclical movements. Regulators do not bite during a boom, only during a low cycle. In banking, for example, the Value-at-Risk model for capital adequacy becomes a challenge when risks are perceived to be very high and credit contracts during a bust period. Likewise, since traditional loan-loss provisioning is based on backward-looking data, it eases during economic upswings and tightens during downswings, amplifying the scope of cycles. To mitigate the problem so that regulation does not amplify bubbles, Goodhart suggests contracyclical provisioning for nonperforming loans. Similarly, Carmichael and Esho recommend dynamic loan-loss provisioning. For instance, following the Spanish approach, financial institutions would be compelled to build up loan-loss provisions in good times in order to mitigate the regulatory hit that they would suffer in bad times. Carmichael and Esho also emphasize the importance of stress testing; regulators would assess banks vulnerability to a variety of shocks by subjecting bank balance sheets to various tests, both models-based and informal tests. They cite the methods used by the Australian Prudential Regulation Authority, which takes a consultative

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approach to prudential regulation, but notes that this approach is costly and requires sophisticated staff. By taking these prudential measures, the regulator can aim to strengthen bank balance sheets, monitor exposure to sectoral lending, and improve prudential rules to avoid exacerbating price cycles. (However, they equally observe that even the most sophisticated regulator cannot be expected to anticipate or counteract asset price cycles.) Developing countries face significant practical hurdles to making these institutional and regulatory improvements work. In The Morning After: Restructuring in the Aftermath of an Asset Bubble, Michael Pomerleano offers empirical evidence that the extent, severity, and duration of price bubbles hinge in part on the availability of financial sector skills and marketbased instruments. Cross-country data point to a positive relationship between the development of financial sector skills and a reduction in the fiscal costs of crises. Where human capital is lacking in the financial sector, assets are inaccurately valued and restructuring proceeds slowly. Therefore, countries need to invest in developing the human capital and market-based instruments that help the developed economies avoid, mitigate, and recover from crises. The implication is that policymakers need to take an active role in investing in the development of the base of professionals actuaries, financial analysts, appraisers,

and insolvency expertsto perform these sophisticated functions. Illustrative initiatives that can facilitate the development of the professionals include the development of formal licensing and accreditation programs for professions, government outsourcing of contracts to the private sector, and increased foreign participation. Looking Forward: Plans for Action to Protect Against Bubbles The final session, Looking Forward: Plans for Action to Protect against Bubbles, represents a prospective effort to identify policy measures. Jaime Caruana, in Banking Provisions and Asset Price Bubbles, concentrates on the pro-cyclicality of loan-loss provisions due to inadequate recognition of latent credit risk. In order to reinforce the solvency of Spanish banks in the medium term, the Bank of Spain adopted statistical provisioning to supplement specific provisioning with the intent of capturing expected losses earlier in the cycle. The contracyclical provisioning offers several advantages. It provides banks with incentives for better risk management, and its anti-cyclical nature mitigates the tendency to reinforce cycles. In Planning to Protect against Asset Bubbles, Vincent R. Reinhart agrees that central banks must pay attention to asset prices but suggests that asset bubbles are difficult to identify in real time or even after the fact. Therefore, tightening monetary policy beyond desired macroeconomic goals in

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response to high and rising equity prices or other asset values would involve trade-offs. Reinhart observes that there are many ways to deal with systemic strains resulting from sharp declines in asset prices. Before the fact, Reinhart advocates working with supervisors to ensure that depositories maintain adequate standards, keeping mandatory capital ratios high enough, and requiring stress tests of critical systems. After the fact, he recommends injecting reserves to meet liquidity needs, lending freely at the discount window, and encouraging participants to continue taking on credit exposure. Finally, he notes that diversified financial systems tend to be more resilient. To an important extent, the U.S. economy is resilient to asset price shocks due to the existence of multiple channels of intermediation; therefore, policymakers should nurture the development of diversified financial systems. In Looking Forward on Monetary and Supervision Policies to Protect against Bubbles, Takatoshi Ito reiterates some of the key messages presented during the conference regarding the role of monetary policy and regulatory and supervisory initiatives. He notes that it is difficult to identify whether asset price increases reflect a permanent productivity increase or a bubble and that there is no theoretical framework to support the contention that interest rate increases would stop asset price increases. He explores several concrete proposals to strengthen regulatory and supervisory

initiatives against bubbles. Foremost among these is ensuring market transparency and regulating the bank loanto-value ratios. Ito observes that Japan was too late in establishing regulations designed to reduce the concentration of lending to real estaterelated sectors. Moreover, the Japanese system created tax incentives to hold properties, and the inheritance tax, in particular, created incentives to increase demand when prices rose. Conclusions The evidence, policy recommendations, and models presented in this volume differ about what monetary policy actions, if any, policymakers should take to protect against bubbles or mitigate their impact. However, several recurring themes and messages are emphasized: Asset price bubbles are very difficult to identify ex ante, because policymakers are constrained by imperfect information, limited effectiveness of policy instruments, the downside risks of misusing instruments, and time constraints. Although many bubble collapses are followed by crises, not all crashes lead to crises that destabilize the financial system; financial systems that have strong supervisory and regulatory institutions and macroeconomic stability before the onset of a bubble tend to weather a bubbles collapse better than systems that do not. Bubbles and crashes occur with greater frequency in emerging,

16 / Asset Price Bubbles

rather than developed, economies because they are more likely to occur when financial markets are opaque, when regulation and supervision are poor, and when lending is based on collateral rather than expected cash flow due to poor accounting standards. Countries that suffer from longer, costlier, and more systemically destabilizing crashes tend also to suffer from poor transparency, weak macroeconomic policies, and microstructural weaknesses in advance of the asset price bubble. This suggests that even more important than the effort to identify bubbles is the effort to establish an effective prudential regulatory regime that will buffer the financial system against the impact of crisis. Transparency minimizes information asymmetries and potential agency problems. Development and enforcement of accounting and auditing standards, including the quality of disclosure and the frequency and means of dissemination, are desirable. Broader, more diversified financial systems spread risks and weather the storm of post-bubble collapses better than more narrow, less diversified systems. Promoting the development of risk-transfer instruments, such as securitized assets, index funds, stock borrowing, lending, and short-selling regimes, and regulated futures and derivatives mar-

ketsto allow for heterogeneity of opinions and allow investors to bet against bubblesis warranted. Strong regulatory and supervisory institutions are always the best line of defense. In this context, maintaining the credibility and reputation of the central bank so that it will be able to carry out its core function maintaining macroeconomic stabilityis essential. In banking systems, a number of authors prescribe efforts to maintain mandatory capital ratios that are high enough, to conduct obligatory stress tests of banking systems and individual banks, to regulate the loan/value ratio (as in the Hong Kong Monetary Authority), as well as to regulate banks to prevent concentration of lending to real estaterelated sectors. Several preventive measures are cited in the capital markets: build the capacity of the technical skills of regulators and financial practitioners; promote investor education; conduct surveillance of concentrations and illicit activities and share information between regulators; institute prudential reporting and dynamic requirements geared to safe and sound clearing and settlements; redesign loan-loss provisioning rules to be less pro-cyclical; assign investigatory and intervention powers and clear legal definitions for different species of property; and design effective disciplinary, civil, and crimi-

Implications for Monetary, Regulatory, and International Policies / 17

nal remedies against perpetrators of stock fraud.

Notes 1. Gerard Caprio and Daniela M. H. Klingebiel, 2002, Episodes of Systemic and Borderline Financial Crises, dataset, available on the Internet at http://econ.worldbank.org/view.php?topic=9&type= 18&id=16172/, July 10.

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Contributors

Franklin Allen The Wharton School, University of Pennsylvania Michael D. Bordo Rutgers University Claudio Borio Bank for International Settlements Michael F. Bryan Federal Reserve Bank of Cleveland Cesare Calari World Bank Gerard Caprio, Jr. World Bank Jeffrey Carmichael Australian Prudential Regulation Authority Jaime Caruana Bank of Spain

Stephen G. Cecchetti Ohio State University Robert S. Chirinko Emory University John H. Cochrane University of Chicago Charles Collyns International Monetary Fund Werner De Bondt University of Wisconsin, Madison, School of Business Neil Esho Australian Prudential Regulation Authority Andrew J. Filardo Federal Reserve Bank of Kansas Benjamin M. Friedman Harvard University

20 / Asset Price Bubbles

Douglas Gale New York University Hans Genberg Graduate Institute of International Studies, Geneva Marvin Goodfriend Federal Reserve Bank of Richmond Charles A. E. Goodhart London School of Economics Santiago Herrera World Bank Richard Herring Wharton School of Business, University of Pennsylvania Patrick Honohan World Bank Takeo Hoshi University of California at San Diego Takatoshi Ito Institute of Economic Research, Hitotsubashi University Steven N. Kaplan University of Chicago Randall Krozner University of Chicago Bruce Lehmann University of California at San Diego

Joaquim Vieira Levy Ministry of Finance, Brazil Philip Lowe Bank for International Settlements Catherine L. Mann Institute for International Economics Ellen R. McGrattan Federal Reserve Bank of Minneapolis Ellen E. Meade London School of Economics and Political Science Allan H. Meltzer Carnegie Mellon University Frederic S. Mishkin Columbia University Ramon Moreno Federal Reserve Bank of San Fransisco Michael Moskow Federal Reserve Bank of Chicago Antu Panini Murshid University of Wisconsin at Milwaukee Michael Mussa International Institute of Economics Kunio Okina Bank of Japan Risn OSullivan Ohio State University

Implications for Monetary, Regulatory, and International Policies / 21

Guillermo Perry World Bank Michael Pomerleano World Bank Edward C. Prescott Federal Reserve Bank of Minneapolis Vincent Raymond Reinhart Board of Governors of the Federal Reserve System Bertrand Renaud World Bank Eric Rosengren Federal Reserve Bank of Boston Anna J. Schwartz National Bureau of Economic Research Abdelhak Senhadji International Monetary Fund Robert J. Shiller Yale University Shigenori Shiratsuka Bank of Japan Larry Slifman Federal Reserve Board The Honorable Jean-Claude Trichet Banque de France Ignazio Visco Organization for Economic Cooperation and Development

Susan Wachter Wharton School of Business, University of Pennsylvania Sushil Wadhwani Bank of England Eugene N. White Rutgers University