Though nearly a decade apart, Japan and the United States both experienced severe stock market and real estate bubbles. Each bubble has its own similarities, but certain structural differences also exist in each country. These two cases help explain the unique circumstances that have marked the creation of and subsequent bursting of the most severe bubbles throughout history.
The Japanese Bubble
Japan's stock market officially peaked on December 29, 1989. This marked the height of its equity bull market, while the height of its real estate bubble occurred approximately two years later. Japan's economy also peaked around this time, having grown by leaps and bounds since the early 1980s, only to grind to a standstill for more than a decade after the bursting of its equity and housing bubbles.
With the benefit of hindsight, signs of Japan's stock market bubble were visible when prices and valuations rose well above historic averages. Price-to-earnings ratios of the Nikkei reached nearly 70 times and property prices rose to such extreme heights that 100-year mortgages were created to allow homebuyers the opportunity to afford houses or condominiums at inflated prices. Similar to a P/E ratio for stocks, the ratio of home prices to household incomes reached record levels in Japan at its peak.
Over-investment, as measured by fixed investment as a percentage of GDP, also reached an alarming height of close to 40% in Japan toward the end of its economic bull run. This was more than double the average ratio in developed countries. Easy credit and easier bank lending helped encourage excessive infrastructure spending, housing creation, export activity and rising equity prices - all of which eventually combined to cause the economy to collapse. The Japanese economy has yet to recover more than two decades later. A key part of this economic malaise was a significant rise in non-performing bank loans and the creation of zombie banks that were weighed down by bad debts for far too long.
The United States witnessed two similar bubbles that were spread over a period of five years, as opposed to the two-year separation between Japan's equity and real estate peaks. Its dotcom bull run ended in March 2000, as theories that a new economic paradigm had been reached thanks to the advent of the internet began to unravel. Excessive P/E multiples at the height of the dot-com bubble led to a flat market for more than a decade. A number of firms reached valuations of more than 100 times earnings during the bubble, and have yet to return to their 2000 stock prices despite earnings growth. (Read more about the dotcom bubble in our Market Crashes Tutorial.)
Easy credit and low interest rates during this period of irrational exuberance sowed the seeds for a growing real estate bubble that is widely believed to have peaked in early 2005 and began unraveling shortly thereafter, accelerating through 2006 and 2007. Excessive mortgage lending and the creation of exotic mortgage backed securities led to a more serious credit crisis. This quickly enveloped countries that lent directly to real estate markets in the United States and also encouraged bubbles in European countries including Ireland, the UK and Spain.
Financial bubbles are well documented throughout history but why investors fail to learn from past mistakes remains somewhat of a mystery. Fortunately for U.S. policy makers, they have had the opportunity to study Japan's responses to its bubbles and learn from many mistakes that were made. For instance, the U.S. government provided rapid and nearly unlimited liquidity at the height of the credit crisis. It did its best to help banks recapitalize and offset bad real estate loans so as to avoid zombie status. Like Japanese officials, the U.S. also increased public borrowing, but it did so at a more significant level to help the private sector clear its debts and refocus on a recovery in its business operations. The Federal Reserve also lowered interest rates to close to zero and kept a loose monetary policy in hopes of avoiding errors that Japan made, such as by increasing taxes too soon and sending the economy back into the doldrums.
Divergent Paths to Recovery
Two decades after Japan's bubble, the country still suffered from deflationary expectations and a lack of confidence in any sustainable improvement in economic growth. A high savings rate and risk-averse culture also mean that investors favor bonds over other asset classes, including equities. This has kept interest rates low and the yield curve flat. A lack of growth and inability to earn a decent spread from short-term and long-term rates has kept banks from being able to earn their way out of a financial recession, solidifying a vicious cycle that pushed the economy from one recession to the next.
The U.S. is widely believed to possess a risk-taking culture that is more willing to learn from and move beyond past mistakes. Consumers and businesses in the U.S. are also not afraid to take on debt. Although this was a main cause of the real estate bubble, it could support a recovery by providing capital. In contrast, Japanese consumers do not openly embrace consumer debt, as evidenced by its high savings rate and willingness to accept low interest rates for safety of principal. Japan does have an advantage over many markets due to the strength of its export markets and large multinational firms that operate on a global scale. An export focus was indeed supporting the economy before the current credit crisis sent global growth into negative territory.
Additionally, western economies are believe to be more open to structural changes to maintain productivity, such as rapid job cuts by U.S. firms to maintain productivity and profitability, and sow the seeds for the next upturn in the business cycle. Immigration trends are also much stronger in U.S. while Japan is faced with an aging workforce and lack of immigration to bring in a constant source of young and motivated employees.
The Bottom Line
In 2010, two decades after the bubble, Japan's equity market was trading at approximately 25% of its peak of 38,916 in December 1989. Its industrial production did not reach its 1991 levels until approximately 2005, and it was dealt another setback when global demand weakened during the 2008 credit crisis. This left GDP again back below levels seen in 1992. During the credit crisis, the U.S. worked to avoid Japan's policy mistakes. At the time of this writing, it remains to be seen whether the programs to encourage economic growth and improve banking profitability will prove sufficient in creating the next boom in the business cycle.
For related reading, take a look at The Lost Decade: Lessons From Japan's Real Estate Crisis.