Why Stock Markets Crash? - Japanese Translation (2003)

Unpublished Preface to the Japanese Edition

the book, available at Amazon.co.jp

As a french kid, I have been raised to envy the North American economic wonders, summarized in sentences such as "what is happening now in France or in Europe has already been going on in the US for the last ten or twenty years;'' Or, "we are lagging behind the US by ten years.'' This certainly applied in 1960s for instance to the generalization of home electronic appliances, to the movie and entertainment industry, to computers, as well as to darker sides such as crimes and social unrests, problems of social integration of different communities, and ... to the penetration of the stock market at many levels of society. But, in the last two decades, I think that Japan rather than the US has led the world with an extraordinary strong economic boom associated in its latest years with one of the largest bubble ever seen, which culminated in december 1989 and was followed by a long stock market depression still continuing with ups and downs at the time of writing. Japan is special in many respects but may be also, as we shall see, a remarkable teaching ground, a predictor of possible scenarios for other countries and a forerunner of the medium and long-term future for the World.

The last twenty years have been remarkable in many ways for the Japanese stock market. To set the scale of the Japan bubble culminating in 1989-1990, the volume of trading on the Japanese stock markets rose from 231 to 2801 billions of US$ (factor 12) from 1983 to 1989, compared to a growth of 797 to 2016 billions of US$ (factor 2.5) on the US stock markets. The weight of Japan measured in stock market world trading volume thus went up from 18.8% in 1983 to 37.5% in 1989 compared to the drop of 64.9% to 27% of the relative weight of the US. The stock market bubble in Japan started to deflate beginning in 1990 and has lost more than 60% of its value. In 1999, nine years after the burst of the Japanese bubble but close to the top of the "new technology'' bubble in the US and in Europe that bursted in 2000, the weight of Japan in terms of trading volume was a mere 5% compared to 53.3% for the US and 9% for the UK.

This book presents a general framework to characterize, quantify, model and predict such bubbles and their aftermath. The main concepts explained and illustrated in details are imitation, herding, self-organized cooperativity and positive feedbacks, leading to the development of endogeneous instabilities. According to this theory, the increase of the interest rate in Japan in 1990 from 2.5% to 6% often invoked as the cause of the burst of the bubble is only one of the triggering factors but not the fundamental cause of the bubble collapse. The book develops a strong series of arguments showing that the true origin of a bubble and of its collapse lies in the unsustainable pace of stock market price growth. As a speculative bubble develops, it becomes more and more unstable and very susceptible to any disturbance. If it has not been the raise of interest rate, it would have been something else.

Japanese markets and Japan's currency, the Yen, are among the most important proponents of this story, making their appearence several times in this book, with the infamous worldwide crash in Oct. 1987, with the study of the correction of the U.S. dollar against the Canadian dollar and the Japanese Yen starting in August 1998 and with the characterization and prediction of the "anti-bubble'' regime discovered with the study of the depreciation of the Japanese stock market after its all-time high at the end of 1989. This book shows that imitation between investors and their herding behavior not only leads to speculative bubbles with accelerating overvaluations of financial markets possibly followed by crashes, but also to "antibubbles'' with decelerating market devaluations following market peaks, that can be modeled by a "log-periodically decorated power law'' decay. There is thus a certain degree of symmetry between the speculative behavior of the "bull'' and "bear'' market regimes. This behavior is documented in details on the Japanese Nikkei stock index since January 1, 1990 and on gold future prices after 1980, both after their all-time highs. Japan also offers an important example of how large trade surplus led to aggressive lending to Asia (from $US 40 billion in 1994 to $US 265 billion in 1997, corresponding to about 40% of Japan total foreign lending), which contributed to a dangerous build-up of debt and excessive property development and manufacturing capacity, deeply associated with the recent crises in Asia.

From the perspective of this book, the antibubble from 1990 to present is all the more interesting because A. Johansen (then my post-doc at UCLA) and I published a prediction in January 1999 of the behavior of the Japanese stock market in the following two years that have been remarkably successful (see Chapters 7 and 9). As we explain later in the book, the fulfillment of this prediction is quite remarkable because it included a change of trend: at the time when the prediction was issued, the market was declining and showed no tendency to increase. Many economists were at that time very pessimistic and could not envision when Japan and its market would rebound. Not only did we predict correctly a rebound of 50% for the end of 1999 but we also foresaw another change of trend at the beginning of 2000. The approval in Oct., 1998 by the Japanese parliament of legislation to allow the government to nationalize failing banks and to commit more than $US 500 billion to rescue the nation's banking system led to a short revival of Japan's economy however bought at the expense of more than $1US trillion in government spending in a series of economic stimulus packages that included numerous public works projects. For all of us humans interested in and frightened by what the future may keep in store, chapter 9 develops further this question and report all cases, successes and failures of our past predictions in several different markets.

The present situation of Japan is no more very different from that of the US after the burst of the "new economy'' bubble in march-april 2000 and the cascade of discoveries (which will probably never be fully unveiled in their full extent) of creative accounting of companies striving to look good in the eyes of analysts rather than to build strong fundamentals. The growing appreciation in 2002 of the crisis in the American financial system is reminiscent of the starting point of Japan's massive financial bubble burst more than 10 years before and of the intertwinning of the bad debts and bad performence of banks whose capital is invested in the shares of other banks, thus creating the potential for a catastropic cascade of bankrupcies. Japan has rediscovered before the US the faults of the 19th century financial system in the US in which stock markets were so much intertwined with their overall banking financial system, that busts and bursts occurred more than once every decade, with firms losing their credit lines and workers and consumers their savings and often their employment. It is often said that the 1930s depression was the last of the stock market and bank-induced economic collapses. The growing fuzziness between financial banking systems and stock markets, in part due to the innovations in information technology, has re-created the climate for stronger bubbles. The big problem is that, in the collapse following them, policy interventions such as lowering interest rates, reducing taxes, and government spending packages may be much less effective, due to several mechanism such as the so-called liquididy trap, a process in which government and the central bank policy becomes essentially useless due to an effective vanishing short-term interest rate, or due to lack of consumer confidence who reduce their consumption and spending. A different and rather drastic solution for the Japanese problem advocated by several economists, which is not without skeptics and critics, is to depreciate significantly the currency, that is, to favor a weak yen policy which allows to obtain a lower real (as opposed to nominal) interest rate. And last but not least but infortunately often forgotten within macroeconomics policies, the human aspect of the problem has to be fully appreciated: how to restore the confidence of Japanese households into a brighter future so that they resume spending and innovating even more rather than saving too much. Saving is a natural reaction to losses but may accentuate the problem by the process of "positive feedback,'' which is dissected in this book. This last ingredient of the problem of Japanese economy is the main theme of the book which focuses on the possible stable and unstable regime shifts resulting from the emergence of collective behaviors of imitation and herding. We argue that standard macro-economic reasoning will not be sufficient as long as one forgets these phenomena, which themselves emphasize a strongly non-linear dynamical view point in order to understand economies and stock markets.

The final and tenth chapter of the book analyzes three pieces of evidence, namely population, gross national product and stock market indices, which suggest all together a fundamental turning point in the race for growth of the human specie. In addition, a prediction is made that starting around 1999, a 5 to 10 years consolidation of international stock markets will occur, allowing a purge after the over-aggressive appetite of the preceding decade. For more than the last two years, this prediction has been born out. With its extraordinary and unparalleled growth, its ensuing decade-long absence of growth, its crowded land, its aging population, is Japan a precursor of the new regime that mankind has to shift to, as discussed in Chapter 10? Shall we learn the lessons of previous bubbles and crashes/depressions and shall we be able to transit to a qualitatively different organization of economic and cultural exchanges?

There is another remarkable feature of the Japanese culture that may be a key ingredient in their long term evolution. It is a common observation by western people that Japanese exhibit reserved behavior, if not bordering to shyness. Actually, my Japanese friends explained to me that this is in large part due to their belief that the rest of the world and in particular the westerners are always more advanced and better in some sense. I also have shared a similar feeling all along my youth to the present day in my education and scientific training, always feeling that others are better than I am. Over the years, I have come to realize that this behavior, sometimes felt as an handicap, is actually the source of future strength and long-lasting inner achievement. Indeed, only by feeling the constant necessity to fill up a gap, by looking above yourself realizing the path still ahead rather than down, can one push oneself again and again to achieve novel heights. I see this strength in the Japanese people. In this sense, Miyamoto Musashi is for me an icon and symbol of a code of conduct striving for achievement above human ambitions for power and recognition, not the least reinforced by my personal interest and practice of Karate.

As this preface shows, I am very happy to see this book translated in Japanese, for I am sure that Japan and the Japaneses have and will play a leading role in the global changes that awaits us in the future. I feel that the remarkable unraveling of the Japanese civilization has probably prepared Japanese people better than other western countries for the revolutions of a different qualitative nature that I foresee ahead of us. On a personal note, I have a high esteem for the Japanese culture and more generally for the East-Asian world. A concrete culinary example is my adoption of chopsticks as the only ustensile, in addition to a knife, that I personally use to eat at home and anywhere. I always travel with a pair of chopsticks. To me, the fork is a rigid and barbarian ustensile very inconvenient for the delicate handling of food. It may also degrade both food savor and temperature. In contrast, wooden chopsticks are marvellous and sophisticated extensions of fingers that provides the pleasure of delicate feeding with soft contact with the mouth and tongue. When guests express their surprise, I explain that it is a good thing to expouse what is best in each civilization and culture. This is one way for a better world communication, in constrast with the present tendancy of adopting a horrible uniformity.

I am particularly grateful to Prof. Hideki Takayasu, now at SONY CSL, a remarkably gifted scientist and in some sense my Japanese-soul-brother not the least in view of our kinness of interest spanning from earthquakes to finance, who first suggested that this book be translated in Japanese. Hideki was also very helpful in securing the agreement between PHP and Princeton University Press. I am also grateful for the careful work that Mieko Yamagishi and especially Hiroyuki Moriya have put in the translation. Hiroyuki Moriya has taken his job of directing this translation very seriously and he has bombarbed me with questions over the year to clarify subtle points to make the translation more accurate. I thank PHP for their interest in this book so early in the process of publication. I feel honored by the implied confidence and respect.

Didier Sornette
Los Angeles and Nice
December, 2002