The crisis.

Abstract

Credit market imperfections have been blamed for the depth and persistence of the Great Depression in the USA. 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 a model of highly levered creditconstrained firms due to Kiyotaki and Moore (1997) 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 ‘knockon’ 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 stabilisation 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.