Roger W Ferguson, Jr: Recessions and recoveries associated with asset-price
movements - what do we know?
Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, at the Stanford Institute for Economic Policy Research, Stanford, California,
12 January 2005.
* * *
Thank you for inviting me to address the associates of the Stanford Institute for Economic Policy
Research; it is a pleasure to be here. As you know, the U.S. economy is currently continuing its
recovery from the relatively mild recession in 2001, which ended the longest period of economic
expansion in our nation's recorded business-cycle history. The 1990s will be remembered not only for
this remarkably long period of prosperity but also for the excitement of the "new economy" and, less
happily, for the sharp decline in equity prices that marked its end. This market correction was most
dramatic in sectors of the economy associated with new technologies, the very sectors that had
experienced the most pronounced run-up in equity prices.
The quick occurrence of a recession following soon after this significant asset-price correction
prompted some observers to suggest that the boom-bust cycle in asset valuations was the proximate
trigger of the economic downturn But a number of aspects of that argument have not yet been fully
examined. In the interest of advancing the understanding on this issue, I will use this opportunity to
provide a retrospective on the performance of the U.S. economy and of some other industrialized
economies during and following recessions over the past three decades or so. In particular, I will focus
on the role that asset prices may have played in expansions and recessions.1 Before going any
further, however, I should emphasize that the views I will express today are my own and are not
necessarily shared by my colleagues in the Federal Reserve System.
What happens during asset-price run-ups?
Asset prices serve multiple roles in a modern economy. They exert a direct influence by affecting the
net worth of the assets' owners. Consumers who hold assets become richer during an asset-price
advance. This so-called wealth effect - always a key determinant of consumption - can be quite
important during significant asset-price run-ups as consumers spend out of their capital gains.
Historical evidence suggests that this effect ultimately raises the level of consumption spending by
between 2 cents and 5 cents per dollar of increase in wealth.2
Similarly, asset prices also affect business balance sheets. Rising prices for assets raise the net worth
of companies that own the assets. The value of the assets that a borrower owns is an important
determinant of his or her creditworthiness. In the event of a default and foreclosure on a secured debt,
collateral that caries a high price provides the lender with a high recovery rate, which makes lending
less risky. During an asset-price boom, the creditworthiness of borrowers rises, the interest rates at
which they borrow decline because of lower risk spreads, and business investment increases as firms
take advantage of the relatively lower interest rates they face.
A consequence of the positive influence of asset prices on investment is that if prospects for
profitability as reflected in asset prices in one sector of the economy are advancing relative to asset
prices in all other sectors, investment in that sector will outpace investment in the rest of the economy,
all else equal. This circumstance may have important and potentially adverse allocative consequences
on the economy. In particular, if asset prices do not accurately reflect the productive potential of the
underlying asset, investment will be channeled to the wrong sectors. However, an asset-price boom in
a specific sector might simply reflect investor expectations of higher productivity rather than a bubble,
a term I will define in a few moments. Investment would still tend to be channeled to that sector, but for
good reason in this instance. One example of a sector-specific jump in asset prices and an associated
investment increase is the case of the U.S. technology sector in the late 1990s. Over the five years
from the end of 1994 to the end of 1999, prices of nontech stocks tripled while those of tech stocks
more than quintupled.3 Correspondingly, the average level of real investment in computers and other
high-tech capital goods was more than 100 percent higher over the 1995-99 period than its level
during 1994, while spending on other types of fixed capital was only about 15 percent higher than in
1994.
Asset-price busts
By definition, an asset-price bust is preceded by an asset-price boom. If a run-up reflects a bubble, the
ensuing price bust could obviously be viewed as its bursting. Alternatively, asset prices may have
been driven up by expectations of a productivity boom, which would lead to improved earnings. In that
case, if the expected productivity boom does not subsequently materialize, asset prices will fall. The
end result in this case would not be termed the bursting of a bubble. Nonetheless, this case may be
indistinguishable from such an experience: Among other common elements, one could also see an
investment overhang in the sector that saw its asset prices rise and subsequently fall.
Recessions are almost always accompanied by asset-price declines. But such declines sometimes
source
appear to be the of adverse surprises, and asset-price busts may subsequently have
disproportionately adverse consequences. Falling asset prices create a negative wealth effect and
restrain consumption. By making collateral less valuable, they also increase the risk of lending to
businesses and thereby worsen the lending terms faced by borrowers. When asset prices fall
substantially, lenders may also find themselves holding substantial amounts of nonperforming loans
that are backed by what may have become, in some cases, worthless collateral. For this reason,
recessions that are preceded by asset-price booms and busts may also be associated with problems
in the banking industry. In such episodes, the ensuing loss of intermediation may serve as an
additional force acting to prolong and deepen what might otherwise have been a milder recession.
Concerns about the severity of downturns that follow significant asset-price collapses suggest that the
identification and analysis of boom-bust asset-price cycles could be useful for policy. For that reason, I
would next like to briefly review some of the issues associated with detecting asset-price bubbles.
Detecting bubbles
The word bubble is sometimes employed to describe any quick and large increase in asset prices, but
a more precise definition would associate bubbles with only those increases in asset prices that are
not due to economic fundamentals.4 Under such a definition, a bubble is present when investors buy
assets at prices above their fundamental values in the expectation of being able to sell them at even
higher prices in the future.5 To be sure, such departures from fundamentals may start small, but over
time they could grow explosively. The fundamental price of an asset typically is defined in terms of the
discounted present value of the income stream or equivalent services that the asset is expected to
provide over time. For stock prices, for example, this is the present discounted value of dividends; for
real estate, it is the discounted value of the rents or services that are expected to accrue to the owner
over time. In theory, the existence of bubbles, defined in this way, is possible in standard asset-pricing
models and may even be consistent with rational, profit-maximizing behavior.6
Ascertaining the existence of bubbles in practice is a very different matter. An immediate difficulty is
that the theoretical notion of the fundamental price does not have an easily measured empirical
counterpart. In part as a result of this measurement problem, statistical tests using historical data
cannot easily distinguish bubbles from failures of the standard asset-pricing model in some other
dimensions, or no failure of the model at all. Indeed, for every study of historical data that finds
evidence of a bubble, often another shows that the findings could be explained by an alternative
specification of the fundamentals in the absence of bubbles.7 That is, even with the benefit of
hindsight, statistical tests attempting to confirm the existence of bubbles in historical episodes can
remain inconclusive.
Of greater relevance for policy discussions, however, is not whether economists can identify a bubble
long after it occurs, but whether the presence of a bubble could be detected in real time, when the
information might be useful for policy decisions. Unfortunately, detection of a bubble, which is
problematic even ex-post, is an even more formidable task and arguably becomes virtually impossible
in real time. Indeed, in real time, it is not uncommon for economists and market participants to fail to
recognize important shifts in underlying trends that may subsequently be viewed as the source of
significant changes in market fundamentals. Current statistical methods are simply not up to the task
of "detecting" asset-price bubbles, especially not in real time, when it matters most.8 "Detecting" a
bubble appears to require judgment based on scant evidence. It entails asserting knowledge of the
fundamental value of the assets in question. Unsurprisingly, central bankers are not comfortable
making such a judgment call. Inevitably, a central bank claiming to detect a bubble would be asked to
explain why it was willing to trust its own judgment over that of investors with perhaps many billions of
dollars on the line.
The issue of detecting bubbles notwithstanding, it is of interest to know whether recessions related to
sizeable asset-price busts differ from other recessions in some way that might be important for policy
considerations.
Are recessions that are related to asset-price busts different?
Two of the longest periods of economic weakness observed in the industrialized world during the
twentieth century are often identified with the asset-price busts that preceded them: the Great
Depression in the United States and the "lost decade" of the 1990s in Japan. In each case, rapidly
falling asset prices, exacerbated by banking problems, marked the beginning of painfully long periods
of economic malaise. In part because of these two experiences, it is sometimes suggested that
assetprice booms more generally lead to imbalances in the economy, and that asset-price busts and the
correction of these imbalances lead to recessions that are longer, deeper, and associated with a
greater fall in output and investment than other recessions. But what is the evidence on this question?
Additionally, can one make any other generalizations concerning recessions that follow asset-price
booms and busts and how they differ from other recessions? To address those questions, it is
instructive to examine recession episodes in the Group of Seven economies since 1970.
Figure 1 presents a bird's-eye view of the evolution of asset prices and the economy from 1970 to
2003 for three of these economies, the United States, the United Kingdom, and Japan.9 For each
country, the top panel of the figure shows the evolution of an aggregate inflation-adjusted index of
asset prices - which consists of an average of stock prices and residential and commercial real estate
prices. The shaded areas cover recession periods, as determined by the business cycle dating
committee of the National Bureau of Economic Research in the United States, and a comparable
methodology for the other countries.10 The bottom panels show the evolution of gross domestic
product in these economies together with a historical estimate of the economy's potential.11
10
To be sure, business cycle chronologies may differ somewhat depending on the underlying methodology. The dates of
peaks and troughs in economic activity for the analysis that follows are from the Economic Cycle Research Institute. For the
United States, these match the dates determined by the National Bureau of Economic Research (NBER). For other nations,
the institute's methodology yields dates that are comparable to the NBER dates for the United States, which facilitates
comparisons across countries. Recession dating is monthly. To obtain the quarterly time series used here, we converted the
monthly expansion/recession phases to a quarterly frequency by designating the cyclical peak (the first quarter of recession)
as the quarter containing the first full recession month - that is, the month following the monthly peak designation. Table 1
shows the dates of all recessions in the sample.
Table 1
1
Business cycles of G7 countries
Peak Trough
2
United States 1969:Q4 1970:Q3
1973:Q4 1975:Q1
1980:Q1 1980:Q2
1981:Q3 1982:Q3
1990:Q3 1991:Q1
2001:Q1 2001:Q3
Japan 1973:Q4 1974:Q4
1992:Q2 1993:Q4
1997:Q1 1999:Q2
2000:Q3 2003:Q1
Britain 1974:Q3 1975:Q2
1979:Q2 1981:Q1
1990:Q2 1992:Q1
Canada 1981:Q4 1982:Q3
1990:Q1 1992:Q1
Table 1 (cont)
1
Business cycles of G7 countries
Peak Trough
Germany 1973:Q3 1975:Q2
1980:Q1 1982:Q3
3
1991:Q1 1994:Q1
2001:Q1 2003:Q2
Italy 1970:Q4 1971:Q2
1974:Q2 1975:Q1
1981:Q2 1983:Q1
1992:Q1 1993:Q3
France 1974:Q3 1975:Q2
1979:Q3 1980:Q2
1982:Q2 1984:Q4
1992:Q1 1993:Q2
1
The quarterly peak and trough dates shown are based on the monthly business cycle chronology from the Economic
2 3
Cycle Research Institute. This episode is excluded because it begins outside of the sample period. This episode is
excluded because it coincides with German reunification.
The relationship of asset prices to the economy near turning points shows varying patterns (figure 1,
top and bottom panels). In some episodes, asset-price declines do not appear to have preceded the
recession. During some recessions, asset prices appear to have simply moved sideways, not
registering substantial declines at all. But in other episodes, significant asset-price booms and
subsequent declines do appear before the onset of a recession and continue during the downturn. For
the United States, for example, the figure highlights the long run-up and subsequent fall in asset prices
before the 2001 recession. The size of these recent movements dominates earlier boom-bust cycles in
the U.S. economy in this sample. For Japan, one can see the remarkable run-up of the 1980s and its
agonizing reversal during the 1990s. For the United Kingdom, one may notice the asset-price
boombust cycle of the early 1970s followed by the painful recession beginning in 1974. Indeed, these three
episodes stand out as perhaps the clearest suggestions of an asset-price boom-bust cycle significantly
influencing or possibly triggering a subsequent recession and recovery.
How do these three cyclical turning points compare with other recessions? To be sure, such a
comparison rests on (1) our identification of these three episodes as the ones that appear to have
been preceded by significant asset-price booms and busts and (2) separating these recessions from
the rest. Such a classification necessarily involves some element of ambiguity, but the three episodes
highlighted in figure 1, the U.S. recession in 2001, the Japanese recession in 1992, and the
U.K. recession in 1974, do appear to stand out.12
11
Estimates of real gross domestic product (GDP), the output gap, potential output, and real investment are from the
Economic Outlook database of the Organisation for Economic Co-operation and Development. The investment data (shown
in later displays) reflect total fixed investment. In figure 1, both actual and potential output are expressed relative to the
value of actual real GDP in 1985. By definition, output should equal the economy's potential - and the corresponding
measure of the output gap should equal zero - when productive factors in the economy are employed at their normal levels.
Output is below the economy's potential when resources are underutilized and above it when the economy is overheated.
To be sure, assessing the economy's potential with much accuracy is inherently difficult, and historical estimates of the
implicit output gap are highly imprecise; however, these measures can serve as helpful summary indicators in historical
comparisons such as those discussed below.
12
There are at least two reasons for the ambiguity in such classifications. The first relates to how one defines an asset-price
bust. The second relates to the dating of cyclical peaks, which, as noted earlier, may differ somewhat depending on the
methodology underlying business cycle chronologies. The three episodes on which I concentrate my attention are relatively
uncontroversial in that the recessions followed rather substantial asset-price boom-bust cycles. But other recessions, which
followed milder boom-bust cycles, could be added to this list. Examples would be the recessions that started in 1974 in the
United States, in 1981 in Canada, and in 1990 in the United Kingdom.
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We have compared the average path of asset prices around the onset of the recession in these three
episodes to the average path of asset prices in the other episodes in our sample (figure 2, top panel).
The vertical line marks the quarter in which the recession began. The dotted curve shows the average
of the three asset-price related episodes, and the solid curve shows the average of the remaining
twenty-two recession episodes in the sample.13 This comparison suggests that in recessions related to
asset-price busts, asset prices fall before the recession more, on average, than they do in other
episodes. This is, of course, as it should be, given our selection criteria for the classification of the
three episodes. The more interesting question is whether these recessions are different in other
dimensions as well.
Consider, for example, the average paths of estimated output gaps during asset-price busts relative to
the remaining recessions (figure 2, middle panel). The data are centered as they were for asset prices,
but the output gap is normalized to equal zero in the first quarter of a recession. As one would expect,
the output gap for both groups of episodes on average falls after recessions start, but it falls less for
the asset-price-bust episodes. Finally, looking at investment (figure 2, bottom panel), the data also
suggest that, on average at least, investment, like the output gap, was not affected more adversely in
the three asset-price-bust episodes. If anything, these three episodes on average appear to be slightly
shallower in terms of output losses and investment declines than the average of other recessions.
But the comparisons of the averages provided in figure 2 could obscure valuable insights that might be
obtained by looking at each of our three asset-price-bust episodes individually, as I do next.
Three asset-price-bust episodes
Let us first examine the U.K. recession of 1974. To put that episode in perspective, we present an
overview of the U.K. economy for the 1970-2003 period (figure 3). The boom-bust cycle that preceded
the 1974 cyclical peak is the most pronounced (and, by the way, not just for the United Kingdom but
for all of the G-7 countries). The large fall in average asset prices (figure 3, top panel) followed the
1973-74 oil crisis, which is also associated with somewhat smaller asset-price declines in numerous
other nations.
We take a closer look at the components of the aggregate asset-price index and compare their
evolution around this U.K. cyclical peak to their average evolution during all recessions excluding our
three asset-price-bust episodes (figure 4). Equity prices registered a remarkably sharp decline in this
episode. But arguably a more distinctive characteristic of this asset-price boom-bust episode is the
swing in real estate prices. Residential real estate prices, and especially commercial real estate prices
(figure 4, bottom panels), also registered rather dramatic declines in this episode. It may thus be
surprising that this recession does not appear to have been deeper than the average of recessions
excluding the three asset-price-bust episodes. The output gap (figure 5) fell along with asset prices
before the recession, but the decline was from an unsustainably overheated level. And investment
(figure 5) stayed relatively strong compared with other recessions. Despite this episode being
associated with rather severe declines in equity and commercial real estate prices, no evidence of an
investment overhang appears in this comparison.
Next, let us turn to the Japanese experience. The Japanese economy saw rapidly increasing equity
and real estate prices during the 1980s (figure 6), a remarkably long period of stability and prosperity.
These run-ups in asset prices were accompanied by a rapid expansion of bank credit, which was
especially important for financing real estate purchases. But asset prices collapsed at the turn of the
decade. This "bursting of the bubble," as the episode is often referred to by Japanese officials, was
followed by a decade of relative stagnation marked by three arguably related recessions.
Concentrating attention on just the first of these three recessions, beginning in 1992, proves
insufficient to capture the severity of the overall problem. The detailed comparisons of the 1992
recession with other episodes (figure 7 and figure 8) do not indicate unusual weakness associated
with the 1992 recession. Rather, the 1990s in Japan are more notable for the succession of
incomplete recoveries than for the recessions themselves (figure 6).
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The bursting of the bubble importantly shaped subsequent developments in this case. The asset-price
collapse hit the Japanese banking system hard, eroding bank capital. The ensuing disintermediation
subsequently proved an important impediment to the economy's recovery. However, the extent of the
problem was not fully appreciated at the time by policymakers. Despite steps toward an expansionary
policy, the monetary easing of the early 1990s was insufficient to mitigate the underlying weakness
during the expansion from 1994 to 1996. The continued fragility of the financial system arguably left
the Japanese economy especially vulnerable to additional disturbances that could have otherwise
been easily weathered. An economic crisis in Southeast Asia, coupled with a previously planned
increase in consumption taxes, resulted in a larger-than-anticipated drag on domestic demand and set
the stage for the recession that started in 1997. Following a brief recovery, monetary policy was
tightened in 2000, and the third recession in a decade followed soon after.
The Japanese experience offers a reminder of the importance of monitoring the health of the financial
system and the need to be especially wary of signs of fragility following a period of sharp asset-price
declines. It also serves to highlight how the behavior of the banking system during the asset-price
run-up may influence subsequent outcomes. Lastly, it points to the potentially crucial role played by
fiscal and monetary policies in recoveries following asset-price-bust recessions.
Last, let us examine the U.S. recession of 2001 and the subsequent, ongoing recovery. We have
prepared the U.S. data in the same manner as in the U.K. and Japanese cases (figure 9-figure 11).
The evolution of disaggregated asset prices (figure 10) shows that the unusually large changes
surrounding the 2001 recession reflected the movement of equity prices alone. Relative to the average
episode, commercial real estate prices neither fell much during the recession nor rose a lot during the
expansion. And instead of declining during the recession, residential real estate prices continued their
upward trend. The behavior of real economic activity around the recent cyclical peak (figure 11)
suggests a second interesting comparison. Relative to other recessions, this recession was shallow
and did not appear to impart an unusual drag on investment, despite the sharp asset-price correction.
Why was the 2001 recession relatively short and shallow even though the preceding swing in asset
prices was so severe? In my opinion, two reasons stand out. The first regards the health of the
financial sector. During the 1980s and early 1990s, the U.S. banking sector faced a succession of
challenges: the savings and loan crisis of the early 1980s, the international debt crisis of the
mid-1980s, waves of bank failures and consolidation, and the need to build capital in response to the
adoption of the Basel I standards in 1988. But by the mid-1990s the banking sector had regained a
solid footing, and regulators were careful to keep it that way. Prudential regulation coupled with good
risk management meant that financial firms limited their exposure to risk during the boom years of the
late 1990s. This approach paid off handsomely when the asset-price break occurred. Despite the
recession, banks remained well capitalized, and their strength eliminated the threat of a vicious credit
crunch or the risk of fragility in the system.
As a result, the elements that appear to have been so detrimental for the recovery of the Japanese
economy during the 1990s were absent during this episode. Following the "bursting of the bubble" in
Japan, the banking system found itself holding a substantial amount of bad loans. And, as already
seen, the woes of the banking system turned into a recessionary force in itself, curtailing the recovery.
This comparison points to a useful policy lesson: A healthy financial sector and strong prudential
regulation during an asset-price boom offer valuable insurance in case the boom turns to bust with an
asset-price break.
The second, and perhaps equally important, reason that the recent U.S. episode was unusually
benign was, in my view, the quick response of policy. Both fiscal and monetary policy were eased
quickly and effectively in this episode. The Federal Reserve cut the federal funds rate rapidly to create
monetary accommodation and maintained conditions of substantial monetary policy ease for a
considerable period well into the expansion. As well, the Administration and the Congress took quick
steps early in the recession to provide fiscal stimulus that helped to prop up aggregate demand.
Placing the policy response in its proper historical context may be critical for drawing the appropriate
policy lessons for the future. Countercyclical fiscal and monetary policies are unlikely to have been as
swift and strong during 2001 had earlier policies not set the stage for such action. On the fiscal side,
the budgetary prudence of the 1990s yielded comfortable surpluses at the onset of the 2001 recession
that facilitated the large fiscal policy easing. And on the monetary side, the successful completion of
the last stage on the long path to price stability during the 1990s allowed substantial easing in
response to the downturn. As policymakers stressed repeatedly, the prevalence of low- and
wellanchored inflation expectations ultimately facilitates pursuit of such countercyclical policy. A clear
lesson emerges from this experience for policy over the long haul. By pursuing fiscal prudence and
price stability during booms, policymakers greatly enhance their ability to take swift, effective
countercyclical action when it is needed most.
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Conclusions
In closing, let me reiterate some of the key points and lessons I draw from this review. First, as already
understood, detecting asset-price overvaluations and undervaluations is controversial in hindsight and
arguably impossible in real time. As a result, although asset-price booms and busts are often linked to
recessions, a clear-cut policy response to suspected waves of exuberance cannot be suggested.
Second, sweeping generalizations regarding asset-price-bust recessions and subsequent recoveries
are not easily made. Idiosyncrasies dominate comparisons in the historical data. As such, each
recession-and-recovery episode would seem to call for its own tailor-made policy response.
Third, to the extent that comparisons across recessions are informative, asset-price-bust recessions
do not appear to be necessarily more costly than other recession episodes. Specifically, at a
macroeconomic level, recessions that follow swings in asset prices are not necessarily longer, deeper,
and associated with a greater fall in output and investment than other recessions. That said, particular
industrial segments and classes of investment, such as the high-tech sector in the recent
U.S. episode, may suffer disproportionately during such recessions. Also, the health of the financial
system, the strength of the banking sector, and the ability and willingness of policy to take appropriate
countercyclical action seem to importantly influence the economic outcomes of an asset-price-bust.
Which brings me to my last point: Over the long haul, preparation for a potential problem seems to be
the best course of action. Prudential supervision and good risk management in banking, and the
pursuit of fiscal prudence and price stability during booms, may ultimately serve as the best insurance
for dealing with the inevitable occasional asset-price breaks observed in our modern economy.