As Figure 1 indicates, it was shall we say an interesting time for researchers from Japan to ask such a question. However, when I inquired about the rapid increase in real estate prices in their country, I always received the same answer – Japan is an island nation and had limited buildable lots, and that prevented real estate prices from declining. This view was very widely held. However, as you can see in Figure 2, that widely held financial myth was soon shattered. Unfortunately, the result of this belief was eventually the crippling of some of the world’s largest financial institutions, a long period of subpar economic growth in Japan, and eventually a problematic deflation that Japan struggles with to this day. A second example is provided by the growth of the Internet, and in particular the growth in “dot-com” stock valuations, in the late 1990s. As Figure 3 shows, there was a substantial run-up in stock valuations during this period. At the time I had conversations with a variety of financial professionals in Boston who made the argument that traditional valuation measures no longer applied. The view assumed by many was that valuation of firms should be based on clicks of a computer mouse rather than earnings, either current or expected in the future. As Figure 4 shows, such enthusiasm for a new way of valuing companies was short-lived. But importantly, the substantial decline in Internet-related stocks did not create a financial crisis.
Many of the positions were equity financed – so, while significant wealth was lost, financial institutions and financial markets did not suffer severe repercussions. That loss in wealth helped ignite the 2001 recession, but it was a much more mild downturn than the one we have experienced of late. With the financial infrastructure not significantly damaged, the impact was much less severe than if individuals and firms had taken highly leveraged positions. 2  BIS central bankers’ speeches  Financial myths in the recent crisis Now I’d like to describe, and present some charts that illustrate, four financial myths that played a role in the recent crisis. Myth 1 – Diversification eliminated the risk of declines in residential real estate holdings Despite the experience of Japan’s real estate in the 1990s, and substantial declines in real estate prices in many regions of the United States throughout history, many commentators argued that a significant, widespread housing-price decline in a country as large and varied as the United States had not happened historically and was very unlikely to occur. That logic was based on what you see in Figure 5, which highlights that there had been significant declines in some regions of the country – but the declines were coincident with increases elsewhere. As Figure 6 shows, there had not been recent, sustained declines in national real estate prices.