Franklin Allen and Douglas Gale
The idea that the amount of money and credit available is an important factor in the determination of asset prices is not new. In his description of historic bubbles Kindleberger (1978, p. 54) emphasizes the role of this factor: "Speculative manias gather speed through expansion of money and credit or perhaps, in some cases, get started because of an initial expansion of money and credit."
In many recent cases where asset prices have risen and then collapsed dramatically, an expansion in credit following financial liberalization appears to have been an important factor. Perhaps the best-known example of this type of phenomenon is the dramatic rise in real estate and stock prices that occurred in Japan in the late 1980s and their subsequent collapse in 1990. Financial liberalization throughout the 1980s and the desire to support the US dollar in the latter part of the decade led to an expansion in credit. During most of the 1980s asset prices rose steadily, eventually reaching very high levels. For example, the Nikkei 225 index was around 10,000 in 1985. On December 19, 1989 it reached a peak of 38,916. A new Governor of the Bank of Japan, less concerned with supporting the US dollar and more concerned with fighting inflation, tightened monetary policy and this led to a sharp increase in interest rates in early 1990 (see Frankel 1993; Tschoegl 1993). The bubble burst. The Nikkei 225 fell sharply during the first part of the year and by October 1, 1990 it had sunk to 20,222. Real estate prices followed a similar pattern. The next few years were marked by defaults and retrenchment in the financial system. The real economy was adversely affected by the aftermath of the bubble and growth rates during the 1990s have mostly been slightly positive or negative, in contrast to most of the postwar period when they were much higher.
Similar events occurred in Norway, Finland and Sweden in the 1980s (see Heiskanen 1993; Drees and Pazarbasioglu 1995). In Norway, the ratio of bank loans to nominal GDP went from 40 percent in 1984 to 68 percent in 1988. Asset prices soared while investment and consumption also increased significantly. The collapse in oil prices helped burst the bubble and caused the most severe banking crisis and recession since the war. In Finland, an expansionary budget in 1987 resulted in massive credit expansion. The ratio of bank loans to nominal GDP