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A Critique of the Literature on the US Financial Debt Crisis

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  • Jerome L. Stein

Abstract

A healthy financial system encourages the efficient allocation of capital and risk. The collapse of the house price bubble led to the financial crisis that started in 2007. There is a large empirical literature concerning the relation between asset price bubbles and financial crises. I evaluate the key studies with the respect to the following questions. To what extent do the empirical relations in the existing literature help to identify asset price bubbles ex-ante or ex-post? Do the empirical studies have theoretical foundations? On the basis of that critique, I explain why the application of stochastic optimal control (SOC)/dynamic risk management is a much more effective approach to determine the optimal degree of leverage, the optimum and excessive risk and the probability of a debt crisis. The theoretically founded early warning signals of a crisis are shown to be superior, in general, to those empirical relations in the literature. Moreover the SOC analysis provides a theoretical explanation of the extent that the empirical measures in the literature can be useful.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2924.

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Date of creation: 2010
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Handle: RePEc:ces:ceswps:_2924

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Keywords: stochastic optimal control; mortgage and financial crises; Ito equation; optimal dynamic risk management; warning signals of crisis; optimal leverage and debt ratios; Congressional Oversight Panel; Case-Shiller index;

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  1. Stein, Jerome L., 2006. "Stochastic Optimal Control, International Finance, and Debt Crises," OUP Catalogue, Oxford University Press, number 9780199280575, September.
  2. Kristopher S. Gerardi & Andreas Lehnert & Shane M. Sherlund & Paul S. Willen, 2009. "Making sense of the subprime crisis," Public Policy Discussion Paper 09-1, Federal Reserve Bank of Boston.
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