Recent financial crisis shows a similar trend where the financial crisis follows an asset bubble. Such an asset bubble could be in stocks or the housing market. What is common is that the assets are not easily unwound given their size of investment (stocks) or long-term nature of the investment (property market). This then makes the asset ill-liquid, and cannot be quickly converted to cash, which if possible, could have at least reduced the impacts and scale of the ensuing financial crisis. Typically, modern financial crisis follows on the heels of asset bubbles that breaks due to sudden amelioration of a key economic externality that fuel the asset bubble in the first place. Take, for example, an asset bubble in property market fuelled by lax government regulations on the number of properties that can be owned as well as weak rules on subletting. This economic externality significantly expanded the capacity of the home renting market which if coupled with an immigration policy focussing on recruiting foreign talent will make investment in the property market followed by renting out the property to foreigners highly lucrative. However, for this scenario to occur, there needs to be large influx of hot money from abroad that invests on building homes in the city driven by the expectancy that home prices will rise and there will be strong demand for new built homes. At the most fundamental level, however, large influx of hot money usually occurs when investors saw a regulatory gap: the externality on lax regulations on number of properties owned and weak rules on subletting. Thus, what is the transmission mechanism on sudden amelioration of the economic externality in a booming property market? If there is sudden withdrawal of lax regulations such as imposing a limit on property owned per investor, or the requirement to sell off excess property within a short time-frame, the flow of hot money will come to a sudden stop, and more significantly, there will be massive withdrawal of funds from the city’s banking system. Such withdrawal of funds will rise interest rate, and making home loans no longer serviceable and unaffordable. This will likely lead to a partial collapse of the new built home market, and massive retrenchment in borrowings in the banking system. Since the property market is deeply intertwined with many sectors of the economy such as construction, steel and glass manufacturing, and the real estate brokering industry, significant unemployment or under-employment will ensue. Overall, it is frightening that major financial crisis can be unwound if critical levers of the economy underpinned by a major economic externality in lax regulations or out-of-equilibrium economic state is ameliorated or withdrawn suddenly. Hence, policymakers must be cognizant of the loan position of different sectors of their economy as well as the whole economy at large. Any out-of-equilibrium loan position should be brought back to equilibrium through well-calibrated policy tools that deflate the asset bubble gradually such as what higher stamp duty can help reduce the property asset bubble in some economies
