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December 21, 2002

Asset Bubbles, Market Crashes And The Dilemmas For Policy Makers
by William Thomson

Financial history is littered with periods wherein a population took a collective leave of its senses and indulged in delusions of ever-expanding wealth. More often than not, the speculation has followed a period of great stability and the introduction of a new technology that has contributed to the ultimately self-defeating speculation. The wealth usually has turned into a mirage and a generation has frequently been scarred by the experience returning to more mundane practices. Asset bubbles, therefore, bring in their wake a very considerable economic cost and it should be the goal of economic policy makers to understand their causes and effects better if these costs are to be contained to a manageable level.

Stock markets are by their very nature volatile. They reflect the collective fears and hopes of traders and investors as they attempt to discount all the known factors affecting the traded instrument. Volatility is therefore normally a healthy and self-corrective mechanism. But just occasionally, excessive liquidity, coupled with visions of a new era, leads to a massive, largely uncorrected rise in valuations that discounts not just the present and the near future but the hereafter as well.

Some historical bubbles
Since the modern concept of the joint stock company began about four hundred years ago there have been many such exercises. Perhaps the earliest was the well-documented Dutch tulip craze in the 1600s, in which supposedly rare bulbs were traded at such increasingly ludicrous prices that some good burghers were willing to trade the family farm for a single bulb. They may have believed the bulb was really worth this amount, more likely they did it with the hope that some bigger fool would give them two farms for the same bulb later. The bursting of the bubble lead to enormous personal financial distress but it also led to the birth of the Dutch tulip flower business that remains an important export business for the country to this day.

Britain as the first country to industrialise on the basis of stock market finance had a history of bubbles in the nineteenth century based on canal and railway finance first in Britain and then increasingly overseas as investment followed the flag. But it is the United States where the largest bubbles have occurred at regular intervals in its expansion over the past two hundred years.

These major speculative bubbles have usually been related to the introduction of new technology that promised untold economic growth and riches. In the 1820s the building of the Erie Canal that opened up northern New York State was financed largely by British money. That early canal was an enormous economic success but it led to the speculative building of further canals that had less and less economic justification. In a pattern common with such speculations, the first mover may be enormously successful but its very success generates copycats whose prime motivation is oftentimes solely stock promotion rather than the establishment of viable businesses.

Some fifty years later, in the aftermath of the American Civil War, the building of the cross-country railroads and the opening of the West led to the greatest speculation in the nineteenth century. Once again, unlimited visions of easy wealth attracted money and people from around the world for financial promotions that were never viable propositions, in which the small investors were almost inevitably ruined by the resulting collapse. Some of the railroads survived and are the backbone of today's US railroads. However, even those survivors that eventually became successful enterprises were the result of mergers and recapitalisations in the wake of the crash. The initial investors saw little or no return.

A half century later, in the after math of the First World War, the boom of the roaring twenties had as it rational the introduction of electric power utilities and the efficiency dreams that generated for an urbanising and industrialising population. These utilities were financed through the stock market and their finance followed a familiar and well- worn path. Although they were essentially mundane businesses with modest and predictable rates of return, they were increasingly packaged as high return instruments through an early form of financial engineering (speculative and leveraged investment trusts) to increase their appeal to a populace again deluded by the promises of instant avarice.

The internet/telecommunications bubble
The wild expansion and speculation of the 1990s related to the introduction of the internet and liberalisation of the telecommunications market can therefore be seen as following in the steps of these earlier infrastructure related booms and busts. Many companies were nothing but frauds worth no more than a dream. To be sold the financial establishment had to develop new valuation methods since the companies had no earnings and no realistic expectation of earnings. To be sold they were 'valued' at multiples of distant revenues. Eventually, the whole facade collapsed but, in the wake of the carnage and wrecked lives, there will still be infrastructure such as broadband in place, unwanted and excessive in capacity at the moment but likely to be used eventually.

But, once again, the costs will have been hugely disproportionate to the gains. Losses to the economy from the stock market alone have already reached one times GDP, and could well go higher. The real initial public investors, as opposed to insiders, will have gained nothing. As greed consumed the players, the restraints on the system itself broke down and became increasingly corrupted. Bankers, accountants, auditors, corporate boards and executives, legislators and regulators all became affected and are to some degree responsible.

This was probably the first mass global speculative mania and, as a result, the banking systems, life insurance industries and corporate pension schemes are weakened on several continents. This will not only impact the lives of participants directly but lead to slower economic growth and reduced living standards for years to come.

The Asian experiences
Until the 1980s Asia had been spared these excessive bubbles. But late in that decade, Japan suffered the so-called 'bubble economy' which was focussed on real estate and the stock market. Coming as the culmination of a forty years economic expansion built on the ruins of war, Japan's excess savings coupled with financial engineering were funnelled into the property and stock markets driving them to ludicrous valuations. At the peak, the value of the land in metropolitan Tokyo was supposedly greater than all the land in the United States. In the stock market, Japan's system of corporate cross holding artificially restricted supply and caused price to earnings valuations to soar to previously unheard of levels.

The subsequent losses have led to a lost decade of growth that has successively crippled the banking in insurance sectors and has depressed economic growth since the bubble burst. Japan's economy today is probably 20-25 percent lower today than if a relatively modest 3 percent growth had been maintained since the markets peaked in 1990. That gap with potential output will grow in the coming years and are a measure of the costs of failing to manage a bubble.

Developing Asia, especially North East and South East Asia were the global development success stories from 1950 till the Asian crisis in 1997. In many ways they were following the models of Japanese success built on export competitiveness, high savings rates and rapidly growing labour forces that were increasingly well educated and able to serve their export industries. But their financial markets together with their legal, regulatory and corporate governance systems did not modernise at the same rate as their real economies.

Again a long period of outstanding economic growth together with what must now be seen as ill-timed financial liberalisation led to an all encompassing over confidence. As a consequence, excessive volumes of property were built with inappropriate foreign currency borrowings. The subsequent bust wrecked the financial systems in several Asian countries leading to severe economic dislocations and years of substandard growth.

Lessons for policy makers
Bubbles, as we have seen, are not a new phenomenon. It seems as if they occur every two or three generations as economies develop. Presumably, that is a long enough period for those presently living to have forgotten the causes of the previous boom and bust and then make go out and them again. If we take the case of the United States, we see that the interval between the present bubble and the previous one in 1929 is longer than that between previous bubbles. That may reflect the relative success of the financial regulatory mechanisms introduced in the 1930s.

The present bubble, on the other hand, may well reflect a failure to update and modernise these same regulatory measures as modern practices evolved. Incompletely thought out deregulatory measures - for local telecommunications companies, the elimination of the Glass Steagal act separating commercial from investment banking and the wild growth of the opaque derivatives markets - have all contributed, as well as a failure to learn properly the lessons of earlier bubbles.

In the case of central banks, new techniques may have to be introduced. The Bank for International Settlements has been studying this area. It appears that the sole focus on price indices as the measure of inflation, whilst ignoring booming asset markets, meant that liquidity conditions were too easy for too long. Ultimately, all speculations depend on the oxygen of liquidity and easy money. Greater cognisance of asset markets would seem to be necessary in the future.

But the tools alone will never be sufficient. There needs to be the political will to use them It is often said that the duty of a central bank is to take away the punchbowl when the party is getting merry. In other words, the central bank should be anti-cyclical not pro-cyclical. But despite their supposed independence, central banks operate in the political world.

It appears that the Japanese central bank knew it had a bubble on its hands for several years before it finally acted. Similarly, the Federal Reserve Board knew there was a bubble brewing in 1996 when the Chairman spoke publicly about irrational exuberance. Further they knew that raising share margin rates could have stopped the bubble before it grew to excessive levels. But a combination of factors: the fear of the domestic political and legislative consequences of reining-in a bull market and a succession of international events - the Asian, Russian, Long Term Capital Markets and Y2K crises - were all rationalisations for inaction, as was the apparent conversion of the Fed Chairman to the nostrums of a productivity miracle in the new economy. The irony of that is that the so-called productivity miracle may itself have been the product of new age Government accounting rather than a genuine phenomenon and a prime example of how bad or politically manipulated Government statistics can lead to bad policy.

Implications for governments and the development agencies
The key global and regional development agencies including the IMF, the World Bank and the Asian Development Bank have been involved with their member countries improving the transparency and integrity of their members banking, financial, legal and bankruptcy systems since the onset of the crisis. Whilst there is room for debate about the effectiveness of some of the advice early in the crisis, on the whole it has been productive. Credible progress has been made in Korea and most South East Asian countries. The regional economies, especially Thailand, are improving again and with their justly famed flexibility have fared quite well in the present global economic downturn. But there is also a tendency for countries to back off from sensitive reforms as their economies improve. Thailand is no exception to this tendency, as indeed are developed economies such as the United States. Whilst this may be an understandable reaction, it is not helpful for the long run. Continued improvements in the operations of the regulatory and legal systems will be needed throughout the region.

In the private sector, the area of corporate governance stands out as an essential area for reform in Asia as well as the developed world. The reforms, however, need to be country specific. No global cookie-cutter, one size fits all will work.

Within Asia, the level of corporate governance is generally recognised as highest in Singapore and Hong Kong, as might be expected for these advanced economies governed by the rule of law with independent regulatory authorities. But per capita income is not the main criteria since India scores better than Japan in average governance levels, as measured by researchers at CLSA Emerging Markets, a regional brokerage house.

Around the region, the general level is much lower although even those economies with low average levels usually have one or two companies that standout on an international scale. Thailand, the Philippines and Indonesia are in this low average corporate governance category with the occasional beacon company.

The record since the Asian crisis shows that those stock markets with higher overall corporate governance levels have fared better than those with poorer levels and the same is true for individual companies. But much remains to be done.

The good news is that the corporate governance trend has been improving since the onset of the crisis and those markets that have done more - even if from a low base - have benefited. Thailand, for instance, is one of the few markets in the world to be up on the year. However, even there, investors maintain a scepticism about markets generally, and business leaders, policy makers and regulators alike must build upon recent gains if the stock market, which is still 80 percent off its highs of 1994, is to fulfil its proper role in financing the growth in the economy. The same applies throughout the region.

Lessons for the US
The United States has obvious lessons to learn with respect to corporate governance as well as the conduct of monetary policy. Corporate governance is being addressed through the legislative agenda - the Sarbanes-Oxley act and the courts. It is clear that the Federal Reserve Board is belatedly attempting to understand what has gone wrong in the management of monetary policy and how to avoid it next time. Recent speeches by the Chairman and other Board members indicate that they are now consumed, at all costs, with avoiding the current deflationary fate of Japan and that of the US in the 1930s.

Unfortunately, their approach appears to be the 'hair of the dog' solution favoured by alcoholics in the morning: "I feel so bad that another drink - i.e., copious quantities of more money - will ease the pain". To date it has largely encouraged consumption by the extraction of housing equity from a newly created housing bubble. That has almost reached its limit as debts have reached unsustainable levels, unless inflation takes off again. Creation of inflation seems to be the Fed's intention and this obviously has adverse implications for the external value of the dollar against other currencies and commodities, including gold.

Bubbles appear fun when they are happening but, like all good parties, there is a price to be paid and it takes time and pain to heal the wounds. Bubbles are not good policy and should be avoided.

William R. Thomson
Chairman of Private Capital Ltd.

William Thomson, Chairman of Private Capital Ltd., an advisory company in Hong Kong. He is also a senior adviser to Franklin Templeton in Hong Kong and Axiom Alternative Funds in London.

Mr. Thomson is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2001-2009 William R. Thomson

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