DP1866 | Asset Bubbles, Domino Effects and 'Lifeboats': Elements of the East Asian Crisis

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Credit market imperfections have been blamed for the depth and persistence of the Great Depression in the US. 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 Kiyotaki and Moore?s (1997) model of highly levered credit-constrained firms 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.