Abstract
The international financial crisis of the late 2000s has naturally led to a resurgence of interest in asset price bubble research. For some, the event confirmed the enduring relevance of studying asset price bubbles in our economies. For others, it was a realization that asset price bubbles are of much greater significance than previously thought.
The financial and policy preconditions that foster frothy asset prices from which bubbles emerge have been the focus of considerable attention. While doubtless important, it is not the only aspect that requires greater understanding. We also need to develop a better understanding of the whole life-cycle of asset price bubbles, from their origins, to their expansion and spread, the inevitable collapse, and the aftermath that has to be cleaned up. It is increasingly recognized that researchers must move on from treating bubbles as one-off, exogenous events. The challenge is to develop a more holistic approach, and then build into our policy models endogenous bubble behavior. Such behavior may indeed be rare but nonetheless has its origins in a number of avoidable factors, not least being some combination of financial fragility, flawed policy frameworks, and poor risk management decisions.
This paper contributes to our understanding of asset price bubbles by looking at one aspect of the recent international financial crisis, namely the financial market spillovers from the West to Asia and the Pacific. Where did it come from and how will it end?
While there are many different ways to conceptualize the spillovers, this paper will focus on the cross-border spillovers that led to severe underpricing of various types of assets in the region. In other words, experience in Asia and the Pacific involves a typically underrepresented protagonist in most crisis stories, a negative asset price bubble. And, just as with the policy response to the bursting of the dot-com bubble in the United States may have contributed to the housing problems in the 2000s, there are concerns that accommodative monetary policy and strong credit growth today in Asia-Pacific economies may be laying the foundation for a round of positive asset price bubbles.
The paper begins with a brief discussion of a negative asset price bubble and a narrative of the international financial crisis in Asia and the Pacific highlighting the timeline of the event. Prior to September 2008, the international financial crisis had had a limited impact on Asia-Pacific markets. To be sure there were periods of unusual stress but, by and large, the region was more focused on macroeconomic policy issues throughout much of the year. That all changed in late 2008 as the region, despite its strong economic and financial fundamentals, entered what was to become a sharp V-shaped business cycle. Through the lens of a negative asset price bubble perspective, this paper helps to shed new light on the unusual dynamics as well as the policy tradeoffs faced during the crisis and afterwards. Asia and the Pacific economies are particularly useful "laboratories" to examine these phenomena because of the diverse economic, financial and policy frameworks in place. The paper also presents a simple model of endogenous asset price bubbles to clarify some of the policy issues. The model assumes there are two regions of the world that are susceptible to domestic asset price bubbles. This type of model emphasizes the highly persistent nature of financial shocks associated with boom-bust dynamics and the potential spillovers across geographic borders. An asset price bubble in one economy can influence the likelihood of an asset price bubble in the other economy. Possibly most important, the actions of the policymaker in one region can affect not only the occurrence of a bubble in its domestic market but also the occurrence of a bubble in the other region. This type of model also elevates the importance of tail risk considerations for policymakers, opening up consideration of more complex monetary policy trade-offs than in conventional macroeconomic models. The paper then explores the implications, combining both the narrative from the crisis and the implications of the theoretical model to understand better the regional policy trade-offs that occurred during the international financial crisis. In addition to emphasizing the critical importance of having strong economic and financial fundamentals going into a crisis period, it also highlights the value of monetary policymakers adopting state-dependent policy frameworks. During normal times, monetary policy focused on price stability makes sense. During crisis times, the priorities of a central bank may need to be adjusted by putting more weight on financial stability than on short-term inflation stability. This comes down to placing more weight on tail risks when making policy decisions. Practically, this means that short-term deviations from (implicit and explicit) inflation targets may be appropriate, if not optimal, when coming out of a crisis. The paper proceeds as follows. Section 2 lays out the basic intuition of a negative asset price bubble. Section 3 reviews the Asia-Pacific experience during the recent international financial crisis, highlighting aspects of this new bubble perspective. Section 4 then presents a simple international monetary policy model with negative asset price bubbles to explore the theoretical channels of spillovers and the policy trade-offs. Section 5 draws on historical narrative and theoretical findings to evaluate the policy implications. Section 6 offers some conclusions.
