bank of japan ’ s november report of recent economic and financial developments1 bank of japan, communication, 20 november 2000. * * * the bank ’ s view2 japan ’ s economy is recovering gradually, with corporate profits and business fixed investment continuing to increase. with regard to exogenous demand, public investment is decreasing gradually since the implementation of the supplementary budget for fiscal 1999 has peaked out. net exports ( real exports minus real imports ) continue to follow a moderate upward trend due to steady developments in overseas economies. as regards domestic private demand, business fixed investment is on an increasing trend. the recovery in private consumption continues to be weak as a whole through lack of notable improvements in employment and income conditions, although there are somewhat positive signs in some indicators. housing investment is mostly unchanged. reflecting such developments in final demand, industrial production is increasing. corporate profits and sentiment continue to improve, and the number of firms that take positive action, such as increasing the amount of fixed investment, is increasing, especially in high - growth sectors. income conditions of households still remain severe but regular and overtime payments as well as new job offers continue to increase in line with the recovery in corporate activities, and compensation of employees has stopped decreasing. as for the outlook, public investment is expected to continue decreasing for the time being. while the u. s. economy is decelerating gradually, the expansion in overseas economies is projected to continue, albeit at a slower pace. in these circumstances, the increase in exports is likely to slow down, as inventories of some raw materials and electronics parts are somewhat excessive at present in asian economies. meanwhile, imports are projected to continue increasing, particularly for those of consumer goods, and capital goods and parts. therefore, net exports will level off for a while. in the corporate sector, firms still strongly feel that they have excess equipment and that they should reduce their debts to restore financial soundness. however, it is very likely that fixed investment in highgrowth sectors, including those related with information technology services, will increase as corporate profits continue to recover. moreover, an improvement in corporate profits will increase household income and this in turn is expected to boost private consumption. however, the pace of recovery in household income will be modest for the time being, since firms ’ perceptions of excess employment still persist, and thus significant changes have not been observed in their efforts to reduce personnel expenses. the increase in industrial production is expected to slow down somewhat for a while mainly because of the slower rise in

##s in a variety of markets including equity, residential and commercial property and corporate bonds. 11 “ apparent arbitrage ” : a third aspect of the failure of emh is evidence of seemingly pure arbitrage opportunities being sustained by market participants for lengthy periods. unlike excess volatility and misalignment, these deviations from fundamentals represent riskless opportunities to make profits. they have been evident in past, and in particular in the present, crisis. ultimately, the importance of these three features is an empirical question. charts 1 and 2 plot the long - run behaviour of the equity market, in the uk from the 1920s and in the us from the 1860s. these long sweeps of history are revealing about patterns of misalignment and excess volatility. in each case, some metric of fundamentals is needed. a model - based measure of fundamentals is used, based on long - run average values of dividend growth discounted at a long - run average real interest rate. 12 for the us and uk, charts 1 and 2 present persuasive evidence of both excess volatility and misalignment. on average over the sample, equity prices in the uk and us are around twice as volatile as fundamentals. the average absolute deviation of uk and us equity prices from fundamentals has been over 20 % and over 30 % respectively. if anything, there is evidence of misalignments having increased. average absolute misalignments have averaged almost 30 % and 70 % in the uk and us since 1980. these deviations from emh are no less striking moving from financial to real assets. since 1930, real property prices have been more than twice as volatile as typical measures of fundamentals. and real property prices have, in different countries, at times deviated significantly from measures of fundamentals over the same period. 13 emh predicts essentially a zero correlation in prices across time, as they follow the random walk of the homeward - bound drunk. this evidence paints a picture of excess volatility ( in the short - run ) and slow mean - reversion ( in the long - run ). in other words, there is both positive ( at short horizons ) and negative ( at longer horizons ) serial correlation in market prices. this leaves emh run - over in both directions. with a steely nerve and deep pockets, investors could make profits from exploiting these trends. but as keynes remarked, the market can often remain