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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Asset Bubbles, Domino Effects and ‘Lifeboats’: Elements of the East Asian Crisis
Hali J. Edison, Pongsak Luangaram, and Marcus Miller
1998-606  (March 1998)

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 credit-constrained 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 ‘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 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.

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Credit market imperfections, asset price bubbles, financial crisis, illiquidity and insolvency

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