Bubbles in Open Economies: Theory and Empirical Detection

Abstract

Common precursors of financial crises are credit expansion and rising leverage fueling bubbles. However, existing bubble literature under rationality lacks explanatory power, and we argue that this is partly due to an implicit focus on closed economies. In open economies, credit bubbles tend to be 'displaced' abroad, have higher incidence, be larger, and last longer. Underpricing of debt is a necessary but not a sufficient condition for risk-shifting to emerge: risk-shifting is induced only after certain leverage. We develop a simple empirical detection procedure of risk-shifting bubbles in open economies. An example of empirical detection is performed on the New Zealand-Japan country pair.

Keywords: asset price bubbles; open economy; risk-shifting; housing market

JEL Classification: D82, F30, G15, R31