The "Bubble" Theory is Full of Hot Air: A Case Study in Japan

It has become an almost universally accepted notion that economies and stock markets occasionally experience "bubbles", during which growth and prices become "unnaturally" high. The presumed outcome is that the market must inevitably come crashing back to "real" levels. While I may question the prices that investors are willing to pay for an individual or group of equities, I disagree with the concept of bubbles almost entirely.

The concept of a "bubble economy" in Japan's 1980s appears to have gained widespread acceptance. But I recently attended a financial discussion group where one Japanese market analyst made a very compelling case challenging the entire Japanese bubble myth…

"I disagree with the notion that the Japanese economy in the late 1980s represents… a "bubble". Market players were correctly pricing a benign inflationary environment and increasing productivity in Japan in the 1980s. What the market at large did not foresee [which] perhaps could be called a ‘widespread error in thinking', was that Japanese politicians would [take] political issue [with] the quickly increasing prosperity.

"Japanese politicians complained that the sharp increases in land and equity prices were creating a society of ‘haves and have-nots'. The theme of ‘social injustice' became headline news. The homeowners were becoming rich while their colleagues on the assembly line remained poor. Something had to be done about this very unJapanese situation, the politicians said.

"The government proceeded to impose heavy taxes and restrictions on land and securities transactions. The central bank -- the Bank of Japan [BOJ] -- was enlisted to do its part to even the score between the haves and have-nots. The central bank aggressively hiked interest rates in order to slow down the supposed speculative frenzy. The BOJ… coined a new phrase to explain the good work they were doing. They assured the Japanese people that they were fighting the ‘bubble economy'. Waving the bubble banner, the government took steps that were inimical to the financial markets and economy. Is it any wonder that land and equity prices collapsed? The collapse was then used as ex post facto proof that a bubble existed."

Economists, politicians and the press speak of the "Japanese bubble" as if it were established fact. Similarly, I'm beginning to see references to a US "bubble economy" and a "stock market bubble". The Japanese press is convinced, although I would argue this is primarily envy-driven.

When interest rates are low and expectations for growth are high, valuations will be higher than periods during which interest rates are high, and expectations for growth are low. Sound economic policies give rise to the former; unsound policies to the latter. Stock markets and economies do not rise and fall precipitously without reason. But a move from sound policies to unsound policies can create dramatic swings in an economy and in its stock market.

When Alan Greenspan spoke of "irrational exuberance" a few years ago, investor's feared he would enact policy to attempt to "deflate the bubble". Fortunately for the market, Greenspan didn't do a thing. Yet there exist a number of bureaucrats who crave to do exactly that. They would like to force the economy and stock market down on the belief that the growth rate in American prosperity is "unsustainable".

There are a number of left-leaning "think tanks" around the world quoting "studies" proving that rising stock markets are to blame for the widening gap between the rich and the poor. The same arguments are being made about the US today as were recklessly tossed about in Japan in the 1980s. While America has been thus far spared of the devastating policies associated with these "experts", other economies around the world have not been so fortunate. Perhaps most frightening, two of the top "policy wonks" responsible for the catastrophic proposals wielded on Asia, Brazil, and Eastern Europe are currently waiting in the wings, hopeful to fill key vacancies arising in the US economic administration within the next two years.

Be very afraid when you hear politicians promulgating the "bubble" theory. They may have the power to enact anti-capitalist policies which will drive down the market, ultimately "proving themselves right".

Andrew West is a Contributing Economics Editor for Capitalism Magazine. In 1997 he received the Chartered Financial Analyst designation from the Association for Investment Management and Research.