Working Paper: CEPR ID: DP2149
Authors: Gregor Irwin; David Vines
Abstract: This paper presents a multiple-equilibrium model of the Asian financial crisis. The economy has Krugman-style over-investment caused by weak financial regulation and exacerbated by government guarantees. Following Dooley, the government only has a limited capacity or willingness to honour such guarantees. The model has a unique long-run equilibrium, with over-investment. But in the short run, in which the capital stock is fixed, it also has multiple equilibria. If lenders regard lending as low-risk, then it is. But if they regard lending as high-risk then the cost of honouring guarantees rises, making the lending high-risk and the risk premium self-justifying. We argue that this model usefully captures the ideas of panic and collapse which have been popularised in Sachs' discussions of the Asian crisis.
Keywords: financial crisis; Asian economic crisis; overinvestment; multiple equilibrium
JEL Codes: E44; F34; O16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government guarantees (H81) | overinvestment (G31) |
| low risk perception (D80) | low interest rates (E43) |
| low interest rates (E43) | investment (G31) |
| high risk perception (D81) | increased cost of honoring guarantees (G33) |
| increased cost of honoring guarantees (G33) | self-justifying risk premium (G41) |
| self-justifying risk premium (G41) | potential crisis (H12) |
| government guarantees (H81) | inevitable crisis (H12) |
| overinvestment (G31) | contraction in capital stock and output (E22) |
| debt stock and output rise (H63) | revert to pre-guarantee levels (N13) |