Though nearly a decade apart, Japan and the U.S. both experienced severe stock market and real estate bubbles. Each bubble has its own similarities, but certain structural differences also exist in each country. These two cases help explain the unique circumstances that have marked the creation of and subsequent bursting of the most severe bubbles throughout history.

The Japanese Bubble

Japan’s stock market officially peaked on Dec. 29, 1989. This marked the height of its equity bull market, while the height of its real estate bubble occurred approximately two years later. Japan’s economy also peaked around this time, having grown by leaps and bounds since the early 1980s, only to grind to a standstill for more than a decade after the bursting of its equity and housing bubbles.

With the benefit of hindsight, signs of Japan’s stock market bubble were visible when prices and valuations rose well above historic averages. Price-to-earnings ratios of the Nikkei reached nearly 70 times and property prices rose to such extreme heights that 100-year mortgages were created to allow homebuyers the opportunity to afford houses or condominiums at inflated prices. Similar to a P/E ratio for stocks, the ratio of home prices to household incomes reached record levels in Japan at its peak.

Over-investment, as measured by fixed investment as a percentage of GDP, also reached an alarming height of close to 40% in Japan toward the end of its economic bull run. This was more than double the average ratio in developed countries. Easy credit and easier bank lending helped encourage excessive infrastructure spending, housing creation, export activity and rising equity prices–all of which eventually combined to cause the economy to collapse. The Japanese economy has yet to recover more than two decades later. A key part of this economic malaise was a significant rise in non-performing bank loans and the creation of zombie banks that were weighed down by bad debts for far too long.

U.S. Bubbles

The U.S. witnessed two similar bubbles that were spread over a period of five years, as opposed to the two-year separation between Japan’s equity and real estate peaks. Its dot-com bull run ended in March 2000, as theories that a new economic paradigm had been reached thanks to the advent of the Internet began to unravel. Excessive P/E multiples at the height of the dot-com bubble led to a flat market for more than a decade. A number of firms reached valuations of more than 100 times earnings during the bubble, and have yet to return to their 2000 stock prices despite earnings growth.

Easy credit and low interest rates during this period of irrational exuberance sowed the seeds for a growing real estate bubble that is widely believed to have peaked in early 2005 and began unraveling shortly thereafter, accelerating through 2006 and 2007. Excessive mortgage lending and the creation of exotic mortgage backed securities led to a more serious credit crisis. This quickly enveloped countries that lent directly to real estate markets in the U.S. and also encouraged bubbles in European countries including Ireland, the U.K. and Spain.

The Consequences

Financial bubbles are well documented throughout history but why investors fail to learn from past mistakes remains somewhat of a mystery. Fortunately for U.S. policymakers, they have had the opportunity to study Japan’s responses to its bubbles and learn from many mistakes that were made. For instance, the U.S. government provided rapid and nearly unlimited liquidity at the height of the credit crisis. It did its best to help banks recapitalize and offset bad real estate loans so as to avoid zombie status. Like Japanese officials, the U.S. also increased public borrowing, but it did so at a more significant level to help the private sector clear its debts and refocus on a recovery in its business operations. The Federal Reserve also lowered interest rates to close to zero and kept a loose monetary policy in hopes of avoiding errors that Japan made, such as by increasing taxes too soon and sending the economy back into the doldrums.

Divergent Paths to Recovery

Two decades after Japan’s bubble, the country still suffered from deflationary expectations and a lack of confidence in any sustainable improvement in economic growth. A high savings rate and risk-averse culture also mean that investors favor bonds over other asset classes, including equities. This has kept interest rates low and the yield curve flat. A lack of growth and inability to earn a decent spread from short-term and long-term rates has kept banks from being able to earn their way out of a financial recession, solidifying a vicious cycle that pushed the economy from one recession to the next.