DP2652 | Government Guarantees, Investment And Vulnerability To Financial Crises

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This Paper presents a new model of the East Asian crisis that combines three elements ? multiple equilibria, investment collapse, and moral hazard ? in a single simple account. We locate the causes of the crisis in poor financial regulation, highly-geared financial institutions, and implicit guarantees to the financial sector that create moral-hazard. The model has a unique long-run equilibrium with over-investment as a result of the guarantees. But in the short run, in which the capital stock is fixed, there may be multiple equilibria. If foreign banks regard lending as low-risk, then it is. But if they regard lending as high-risk and charge a higher interest rate, then the costs of honouring guarantees rises, making the lending high-risk and the risk premium self-justifying. A crisis occurs with a switch to this second equilibrium in which the government is forced to renege on its guarantees; the effect is a reversal of foreign capital flows. Whether multiple equilibria exist ? and hence whether the economy is vulnerable to a crises ? depends critically on the extent of capital accumulation and the mix between debt and equity financing.