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: www.cepr.org/pubs/dps/DP1866.asp

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.