Kiyohiko G Nishimura: How to detect and respond to property bubbles -
challenges for policy-makers
Remarks by Mr Kiyohiko G Nishimura, Deputy Governor of the Bank of Japan, at the
Reserve Bank of Australia-BIS Research Conference "Property markets and financial
stability", Sydney, 21 August 2012.
* * *
Let me begin by commending the impressive achievements of this BIS project, as
exemplified by the presentations yesterday and this morning. In this regard, I am sure you
will join me in applauding the efforts of Frank Packer and his accomplished colleagues at BIS
Asia & Pacific. In spite of this impressive progress, however, I still think that we are only at
the starting line: many problems remain to be solved before this project can provide
guidelines for policy-making. Learned academics may be experts in "explaining" the causes
and effects of past events that have shaken the world. To put it metaphorically, failures in the
last war are always scrutinized thoroughly, and their lessons are presented. In contrast, we
policy makers should be looking forward into the future. We should not be fighting the last
war when things are changing rapidly, no matter how well we may have learned the lessons
of the last war.
The two main questions from the policy maker's point of view are: How can we detect malign
property bubbles? and, How should we respond to them?
1. How to detect malign bubbles
Let me start with the first question: How can we detect malign bubbles? Here we should be
aware that not all property bubbles lead to financial crises, and not all financial crises are
preceded by property bubbles. International panel studies have shown that two-thirds of
46 systemic banking crises were preceded by house price boom-bust patterns, while 35 out
of 51 house price-bust episodes were followed by a crisis.1 So there are both malign bubbles
and benign ones.
Then, what leads to a malign bubble? Looking back at past experience of malign bubbles, we
find another factor which has not been touched upon by the presentations so far: the
demographic transition from a "population dividend" to the "burden of an ageing population."
Let us look at the charts comparing the Japanese property bubble of the 1990s, the US
house price bubble of the 2000s, and the possible Chinese property bubble. In these three
charts, I juxtapose, first, the ratio of working-age population to the rest (the inverse
dependency ratio), second, the real property price index, and third, total loans in real terms.2
In Japan (Chart 1), we have two peaks in the working-age population ratio, accompanied by
two peaks in the real property price index, which is the real land price index. Of these two,
the second peak, around 1991, happened to be a malign bubble which triggered a
subsequent long period of stagnation. Then, what is the difference between the two? The
volume of total loans in real terms may suggest an answer. Real loans were increasing at the
time of the first peak, but their level was not as high as during the second peak.
A remarkably similar picture is found in the United States (Chart 2). We have two peaks in
the working-age population ratio, though not as pronounced as in Japan. And the real
property price index, which is the real house price index, seems to have two peaks, roughly
coinciding with the demographic change. Again, the second peak triggered the financial crisis
of 2008, though the first peak coincided with the S&L problem, which had a far less severe
effect on the economy. Adding the real total loans to the chart, we find a quite similar pattern
to the Japanese case. The level of the real total loans in the first peak was high, but far lower
than in the second peak.
The last chart shows the figures for China (Chart 3). China has not yet peaked with respect
to working-age population ratio, but it is close. The property price index was taken from the
web site of a Shanghai index provider, who unfortunately and unexpectedly shut down their
site and vanished about a year ago (June 2011). I tentatively use this index since it has a
longer span than other indexes, although I am not entirely sure how it was constructed. The
chart shows a clear upsurge in property prices up to 2010. Again the real total loan also
shows a tremendous increase along with the working-age population ratio and the property
price index.
What lessons can we learn from this rather cursory examination of the recent history of two
advanced economies and the present situation of one emerging economy? It is clear that not
every bubble-bust episode leads to a financial crisis. However, if a demographic change, a
property price bubble, and a steep increase in loans coincide, then a financial crisis seems
more likely. And China is now entering the "danger zone."
Although demographic factors are not the subject of the studies in this conference, there is a
growing body of cross-national evidence that compositional change in population has a
significant effect on property prices (especially the land component).3 This comes as no
surprise since, in the population dividend phase, young baby boomers want to buy more land
and save more real money for their retirement. Since the supply of land is physically limited,
the real price of land will go up. Similarly, if nominal money supply is held constant, the
"price" of real money holdings, which is the inverse of the price level, should also go up,
implying deflation. Being mandated to maintain price stability, the central bank is then likely
to increase nominal money to keep prices stable. The result is an increase in property prices
while general price levels remain stable.4
However, this raises the problem of quantitative significance. Though this hypothesis can
explain "correlation" qualitatively, it is not sufficient to explain these malign property price
bubbles quantitatively. The magnitude of these bubbles is simply mind-boggling. Also, not
every country experiencing this sort of demographic change has a malign property bubble
and a financial crisis. Therefore, we should not think of this strong positive correlation
between demographic factors and malign bubbles as a strict causal relationship. Rather we
should regard the demographic conditions of population dividend as "fertile ground" for
malign property bubbles.
In the final analysis, malign property bubbles can be considered a manifestation of overly
optimistic expectations at their extreme.5 Since the financial crisis, many attempts have been
made in the economic profession to explain malign bubbles as the consequences of rational
economic agents acting under circumstances of asymmetric information and certain
not-soefficient regulatory conditions. These explanations are quite ingenious, using arrays of
sophisticated neoclassical apparatus. However, from the practitioner's viewpoint, it is more
helpful simply to admit the frailties of human nature whereby we are so prone to be overly
optimistic in some cases (and overly pessimistic in others), and our decisions are so easily
influenced by other people's opinions, especially the opinions of those in the higher realms of
policy making. I will come back to this point later.
2. How to respond to a malign bubble
Let me now turn to the second issue, which is how we should respond to a malign bubble.
Fundamentally, we should distinguish two stages in the history of a malign bubble. The first
is the early or prevention stage of the bubble, while the second is the late or collapsing stage.
When considering our response to the early or prevention stage of a bubble, a consensus
seems to have emerged in favor of the so-called BIS view. First, use various
macroprudential policies to rein in overly optimistic expectations in the market. Second, if the
bubble is truly malign, we should not hesitate to use monetary policy as well. Third, in using
macro-prudential measures we should be aware of their long-run consequence of distortion
in resource allocation.
However, in practice, I have strong reservations over the effectiveness of some
macroprudential measures in a malign bubble. Take the loan to value (LTV) ratio as an example. In
the heyday of a ballooning bubble, the denominator of the LTV, i.e., the market value of
property, goes up higher and higher. Thus, the LTV that seemed sufficient to cap the loan
volume becomes grossly insufficient in a few months or even weeks. The same is true for
quantitative constraints on loans, since instruments bypassing the constraints emerge, as
exemplified in the experience of the Japanese property bubble of the 90s.6 Moreover,
macroprudential measures are sometime used to halt the advance of a bubble only temporarily,
which eventually comes to the surface again later with greater force than before. So an
apparent success in the present may be an omen of failure in the future.
There is another issue which has been unfortunately overlooked in the discussion of dealing
with a bubble, but is potentially most problematic of all: communication with the public. How
can policy makers convince the public that we are facing a ballooning malign bubble when
there is no apparently imminent threat to the system? It is extremely difficult to persuade
people who (want to) believe "this time is different" and are convinced they are now on the
foothills of eternal prosperity, just as long as their path is not blocked by some stupid policy
maker. In retrospect, I have to point out sadly that the public sector is often partly responsible
for nourishing such overly optimistic expectations in the public.7
Although I have expressed some reservations so far about the emerging policy consensus in
the early or prevention stage of a malign bubble, these problems are almost trifling in
comparison to the daunting policy difficulties faced in the late or collapsing stage. To my
disappointment, there has been little discussion dealing squarely with these difficulties.
In the late stage of a bubble, there is, on the one hand, a danger of restraining policy being
"too little, too late", and just postponing the collapse until a later stage and on a larger scale.
On the other hand however, there is also the danger of too bold a policy leading to an
"overkill" of the economy.
Most difficult, however, is the appropriate response during the collapsing stage of malign
bubbles. First, the magnitude of the collapse is mind-boggling. Chart 4 shows first the real
property price movement of Japan. Here I use the RRPI index for greater Tokyo (roughly
10% of the total population), which is the quality-adjusted condominium price index. Then I
have added the US real property price movement of 10 cities (again roughly 10% of the total
population), which is based on the S&P Case-Shiller index. The magnitude of the price
decline is clear: Japanese real residential property prices at their lowest point are only one
third of their peak. In the United States, real residential property prices are currently more
than 40% lower than their peak. At this moment, it is not clear whether US prices have hit the
bottom. In any case, a decline of this magnitude implies a severe balance-sheet adjustment
for the economy.
Moreover, this severe balance-sheet adjustment, which is necessary for sustained recovery,
is taking place when demographic factors are changing from positive (population dividend) to
negative (burden of an ageing population) in Japan and the United States, as already shown
in Charts 1 and 2. A severe balance-sheet adjustment under population ageing hampers the
effectiveness of conventional policy tools. Moreover, seemingly overly pessimistic
expectations aggravate the problem of policy effectiveness.
The disturbing fact is that little is known about the appropriate policy for the late or collapsing
stage of a malign bubble. What tools are available? What are the pros and cons of their use?
These are the most pressing challenges for policy makers, and they should form the
research agenda of the immediate future.
So in conclusion, I'd like to reiterate again that we are still only at the starting line. Thank you
for your kind attention.
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