Is it Possible to Predict a Bubble Burst?

Faculty Fellow, RIETI

In recent years, there has been an increase in the number of financial institutions recommending apartment or condominium construction to elderly landowners as an inheritance strategy, and offering financing. If the number of dwellings increase in Japan, where the population is decreasing, a price collapse may seem inevitable, however, at present, there is no such noticeable decline. In view of this fact, some authorities fear a mini housing bubble may be underway. It has long been said that China has a real estate bubble, however, prices continue to rise, defying the fear of a bubble burst, and in Beijing and other cities, housing prices have skyrocketed to many multiples above the average annual income.

Such bubble-related phenomena are extremely important for the future prospects of the economy.

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When the price of an asset is rising, the portion exceeding the price that can be explained by earnings (the price justified by fundamentals) is called a bubble.

Papers written by Paul Samuelson in 1958 and Jean Tirole in 1985 are well-known examples of classical theory regarding bubbles. Classical theory stipulates that if bubble assets occur in economies in which capital investment is excessive to begin with, companies use capital to purchase bubble assets and reduce capital investment, thus, increasing economic efficiency.

The Samuelson-Tirole model states that bubbles increase spending and reduce investment. This is inconsistent with the actual bubble economy experience of a rise in both spending and investment. Also, in this theory, as long as the bubble does not burst, it is a beneficial presence which raises economic efficiency. This also differs from actual experience. It is an empirical fact that a bubble period is a hotbed of inefficiency, with rampant corruption and wrongdoing at financial institutions and other entities, however, this does not occur in the classical theory.

In recent years, a bubble theory has been created in which both spending and investment increase, and it is used to analyze various economic phenomena. This began with the paper written by Pompeu Fabra University Professors Alberto Martin and Jaume Ventura in 2012.

In the Martin-Ventura model, companies have borrowing restrictions, thus limiting their investment in capital. Furthermore, companies with high productivity and low productivity coexist. In this economy, if companies with high productivity sell bubble assets to those with low productivity and invest in capital, capital investment by the former increases, while investment by the latter decreases. The bubble reduces inefficient investment and increases efficient investment. In the economy overall, the total amount of spending and investment increases.

Bubble research based on this model has grown, and Japanese researchers are significantly contributing in this field. Such research includes a 2017 paper by University of Tokyo Lecturer Tomohiro Hirano and Professor Noriyuki Yanagawa; a 2015 paper by Hirano, Yanagawa, and Kansai University Professor Masaru Inaba on bubbles and government intervention; and a 2015 paper on bubbles and banks by University of Tokyo Professor Kosuke Aoki and European Central Bank Senior Economist Kalin Nikolov.

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In such bubble research, it is postulated that bubble generation and burst occur because of exogenous shocks, and cannot be predicted. On the other hand, in reality, there exists a strong need to predict the burst of a bubble. However, that need is not sufficiently fulfilled.

Incidentally, unique research which predicted a bubble burst exists in the econophysics field. ETH Zurich Professor Didier Sornette applied a condensed matter physics model to housing price fluctuations in his 2005 paper and predicted that a bubble burst would occur in 2006 in U.S. housing prices (The actual burst began in 2006). However, the paper does not show the economical basis for using a condensed matter physics model to explain housing prices.

To understand bubble generation and burst, it is necessary to understand the expectations of fluctuations. Bubble equilibrium is when everyone thinks everyone else is buying bubble assets, so they buy them too (expecting prices to rise), and as a result, the prices rise as predicted. On the other hand, bubble burst equilibrium also exists. This is when everyone thinks everyone else is selling bubble assets, so they sell them too (expecting prices to fall), and as predicted, the prices slump.

Bubble equilibrium or bubble burst equilibrium is a kind of regime change (framework conversion), and occurs because of the change in people's expectations regarding people's behavior. This is not just "your expectations regarding my actions" or "my expectations regarding your actions." It includes the endless loop of "my expectations regarding your expectations regarding my actions" and "your expectations regarding my expectations regarding your expectations regarding my actions..."

Since the 1990s, the field of "global games" has been developing as a theory which enables easy analysis of the fluctuations in expectations set by this endless loop. In a series of research, which includes the 1998 paper by Princeton University Professor Stephen Morris and Bank of International Settlements Economic Adviser Hyun Song Shin showed within the global game framework that if there is noise in the information held, regime change caused by fluctuations in expectations can be predicted from economic fundamentals.

Until now, global games have been applied in the analysis of currency and banking crises, but as far as I know, it has not been used in the research of bubble bursts. I am conducting simple global game research which sets bubble asset quantity as an economic fundamental. In this model, under certain conditions, the bubble price is uniquely set by the fundamental value, so the uncertainty of multiple equilibria disappears. Specifically, if the bubble asset quantity growth rate exceeds a certain value, the bubble price sharply declines, and then gradually recovers. This phenomenon can be regarded as the bubble burst and creation cycle.

A 2003 paper written by Princeton University Professors Dilip Abreu and Markus K. Brunnermeier predicts bubble bursts from economic fundamental conditions, but it is somewhat difficult to understand. Applying global games to create an easy-to-use theoretical model is one future course of action.

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Another issue in bubble research is the implication of the theoretical model which states that bubbles (as long as they do not burst), raise economic efficiency and welfare. It is viewed as an empirical fact that bubbles cause corruption and inefficiency, however, there is no theoretical model which shows this expressly. A hint to solving this problem lies in making the bubble asset supply endogenous.

In existing bubble theory, bubble asset supply volumes are set exogenously, and cannot be changed by the behavior of people or corporations. However, in reality, bubble asset supply volumes are set by people's behavior. During the bubble period, people forcibly developed extremely cheap land, and sold it at a high price. Bubble assets (land) were "produced" and sold. The produced land was inefficient, and inefficiency accumulated in the economy as a whole. If we consider the phenomenon of "intentional production of bubble assets," it is thought that we will be able to more accurately analyze the inefficiency of bubbles we face in the real world.

Bubble research has the potential for development in various directions. We should expect to see research development in the future.

>> Original text in Japanese

* Translated by RIETI.

October 17, 2017 Nihon Keizai Shimbun

November 14, 2017

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