DATING THE TIMELINE OF FINANCIAL BUBBLES DURING THE SUBPRIME CRISIS By Peter C. B. Phillips and Jun Yu September 2010 COWLES FOUNDATION DISCUSSION PAPER NO. 1770 COWLES FOUNDATION FOR RESEARCH IN ECONOMICS YALE UNIVERSITY Box 208281 New Haven, Connecticut 06520-8281 http://cowles.econ.yale.edu/Dating the Timeline of Financial BubblesDuring the Subprime Crisis1Peter C. B. PhillipsYale University, University of Auckland,University of Southampton & Singapore Management UniversityJun YuSingapore Management UniversityAugust 31, 20101Phillips acknowledges support from the NSF under Grant No. SES 06-47086. Yu acknowledgessupport from the Singapore Ministry of E du cation AcRF Tier 2 fund under Grant No. T206B4301-RS. Peter C. B. Phillips, Cowles Foundation for Research in Economics, Yale University, Box 208281,Yale Station, New Haven, Connecticut 06520-8281. Email: p [email protected]. Jun Yu, School ofEconomics and Sim Kee Bo on Institute for Financial Economics, Singapore Management University, 90Stamford Road, Singapore 178903. Email: [email protected] new recursive regression methodology is introduced to analyze the bubble characteristicsof various …nancial time series during th e subprime crisis. The methods modify a techniqueproposed in Phillips, Wu and Yu (2010) and provide a technology for identifying bubble be-havior and consistent dating of their origination and collapse. The tests also serve as an earlywarning diagnostic of bubble activity. Seven relevant …nancial series are investigated, includ-ing three …nancial assets (the Nasdaq index, home price index and asset-backed commercialpaper), two commodities (the crude oil price and platinum price), one bond rate (Baa), andone exchange rate (Pou nd /USD). Statistically signi…cant bubble characteristics are found inall of these series. The empirical estimates of the origination and collapse dates suggest aninteresting migration mechanism among the …nancial variables: a bubble …rst emerged in theequity market during mid-1995 lasting to the end of 2000, followed by a bubble in the realestate market between January 2001 and July 2007 an d in th e mortgage market between No-vember 2005 and August 2007. After the subprime crisis erupted, the phenomenon migratedselectively into the commodity market and the foreign exchange market, creating bubbles wh ichsubsequently burst at the end of 2008, just as the e¤ects on the real economy and economicgrowth became manifest. Our empirical estimates of the origination and collapse dates matchwell with the general datetimes of this crisis put forward in a recent study by Caballero, Farhiand Gourinchas (2008).Keywords: Financial bubbles, Crashes, Date stamping, Explosive behavior, Mildly explosiveprocess, Subprime crisis, Timeline.JEL classi…cation: C15, G12There is a very real danger, fellow citizens, that the Icelandic economy in theworst case could be sucked into the whirlpool, and the result could be national bank-ruptcy (Prime Minister Geir Haarde, televised address to Icelandic Nation, October8, 2008)Between 40 and 45 percent of the world’s wealth has been destroyed in little lessthan a year and a half. (Stephen Schwarzman, March 11, 2009)Federal Reserve policymakers should deepen their understanding about how tocombat speculative bubbles to reduce the chances of another …nancial crisis (DonaldKohn, Federal Reserve Board Vice Chairman, March 24, 2010)1 IntroductionFinancial bu bb les have been a longstanding topic of interest for economists, involving boththeorists and empirical researchers. Some of the main issues have focused on mechanisms formodeling bubbles, reconciling bubble-like behavior in the context of rational expectations offuture earnings, mechanisms for detecting bubbles, and measuring their extent, exploring causesand the psychology of investor behavior, and considering suitable policy responses. While thereis general agreement that …nancial bubb les give rise to misallocation of resources and can haveserious e¤ects on real economic activity, as yet there has been little consensus among economistsand policy makers on how to address the many issues raised above.The global …nancial turmoil over 2008-2009, triggered by the subprime c risis in the USand its subsequent e¤ect on commodity markets, exchange rates and real economic activity,has led to renewed interest among economists in …nancial bubbles and their potential globalconsequences. There is now widespread recognition among policy makers as well as economiststhat changes in the global economy over the last decade, far from decoupling economic activityas was earlier believed, have led to powerful latent …nancial linkages that have increased risksin the event of a large common sh ock. The magnitude of the crisis is so large, the mechanismso complex, and the consequences so important to the real economy that understanding thephenomena, exploring its causes and mapping its evolution have prese nted major challenges tothe economics profession. As the headers that lead this article indicate, a substantial percentageof the world’s accrued wealth has been destroyed within 18 months of the subprime crisis withmanifold e¤ects ranging from the collapse of major …nancial institutions to the near bankruptcyof national economies. There is also recognition that new emp irical method s are needed toimprove u nde rstanding of speculative phenomena and to provide early warning diagnostics of1Figure 1: Time series plots of real p rices for three …nancial assets: monthly observations on theNasdaq index from February 1973 to January 2009; monthly observations on the house priceindex from January 1987 to January 2009; monthly observations on the outstanding value ofasset backed commercial paper from January 2001 to January 2009. All series are normalizedby the CPI. The estimated bubble origination and collapse dates are also shown on the …gures.…nancial bubbles.The recent background of …nancial exuberance an d collapse with concatenating e¤ectsacross markets and nations provides a rich new environment f or empirical research. The mosturgent ongoing questions relate to matters of …scal, monetary, and regulatory policies for se-curing …nancial stability and buttressing real economic activity. In this regard, there have beenserious disagreements among economists and policy makers about the e¤ectiveness and con-sequences of various bailout and recovery plans