Asset Bubbles, Domino Effects and 'Lifeboats' Elements of the East Asian Crisis
35 Pages Posted: 8 Aug 1998
Date Written: March 1998
Credit market imperfections have been blamed for the depth and persistence of the Great Depression in the USA. Could similar mechanisms have played a role in ending the East Asian miracle? After a brief account of the nature of the recent crises, we use a model of highly levered credit-constrained firms due to Kiyotaki and Moore (1997) to explore this question. As applied to land-holding property companies, it predicts greatly amplified responses to financial shocks--like the ending of the land price bubble or the fall of the exchange rate. The initial fall in asset values is followed by the "knock-on" effects of the scramble for liquidity as companies sell land to satisfy their collateral requirements--causing land prices to fall further. This could lead to financial collapse where--like falling dominoes--prudent firms are brought down by imprudent firms.
Key to avoiding collapse is the nature of financial stabilization policy; in a crisis, temporary financing can prevent illiquidity becoming insolvency and launching "lifeboats" can do the same. But the vulnerability of financial systems like those in East Asia to short-term foreign currency exposure suggests that preventive measures are also required.
JEL Classification: F3, G1, E5
Suggested Citation: Suggested Citation