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

Author(s): Hali J Edison, Pongsak Luangaram, Marcus Miller
Publication Date: April 1998
Keyword(s): asset price bubbles, Credit Market Imperfections, Financial Crisis, illiquidity and insolvency
JEL(s): E32, G21, G32, G33, O54
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1866

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.