Working Paper: NBER ID: w11618
Authors: Ricardo J. Caballero; Arvind Krishnamurthy
Abstract: Emerging market economies are fertile ground for the development of real estate and other financial bubbles. Despite these economies' significant growth potential, their corporate and government sectors do not generate the financial instruments to provide residents with adequate stores of value. Capital often flows out of these economies seeking these stores of value in the developed world. Bubbles are beneficial because they provide domestic stores of value and thereby reduce capital outflows while increasing investment. But they come at a cost, as they expose the country to bubble-crashes and capital flow reversals. We show that domestic financial underdevelopment not only facilitates the emergence of bubbles, but also leads agents to undervalue the aggregate risk embodied in financial bubbles. In this context, even rational bubbles can be welfare reducing. We study a set of aggregate risk management policies to alleviate the bubble-risk. We show that liquidity requirements, sterilization of capital inflows and structural policies aimed at developing public debt markets "collateralized" by future revenues, all have a high payoff in this environment.
Keywords: bubbles; capital flow volatility; risk management; emerging markets
JEL Codes: E32; E44; F32; F34; F41; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lack of adequate domestic financial instruments (F65) | capital outflows (F32) |
| capital outflows (F32) | emergence of bubbles (E32) |
| domestic financial underdevelopment (O16) | emergence of bubbles (E32) |
| bubbles provide domestic stores of value (D14) | increase investment (E22) |
| bubbles expose economies to risks of crashes (F65) | reversals in capital flows (F32) |
| private sector's underestimation of risks (D80) | social undesirability of rational bubbles (E32) |
| aggregate risk management policies (G52) | mitigate risks associated with bubbles (E32) |