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Government Guarantees, Investment And Vulnerability To Financial Crises

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  • Irwin, Gregor
  • Vines, David

Abstract

This Paper presents a new model of the East Asian crisis that combines three elements – multiple equilibria, investment collapse, and moral hazard – in a single simple account. We locate the causes of the crisis in poor financial regulation, highly-geared financial institutions, and implicit guarantees to the financial sector that create moral-hazard. The model has a unique long-run equilibrium with over-investment as a result of the guarantees. But in the short run, in which the capital stock is fixed, there may be multiple equilibria. If foreign banks regard lending as low-risk, then it is. But if they regard lending as high-risk and charge a higher interest rate, then the costs of honouring guarantees rises, making the lending high-risk and the risk premium self-justifying. A crisis occurs with a switch to this second equilibrium in which the government is forced to renege on its guarantees; the effect is a reversal of foreign capital flows. Whether multiple equilibria exist – and hence whether the economy is vulnerable to a crises – depends critically on the extent of capital accumulation and the mix between debt and equity financing.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2652.

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Date of creation: Dec 2000
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Handle: RePEc:cpr:ceprdp:2652

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Keywords: East Asian Economic Crisis; Financial Crisis; Multiple Equilibrium; Over-Investment;

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Cited by:
  1. Vaugirard, Victor, 2007. "Bank bailouts and political instability," European Journal of Political Economy, Elsevier, vol. 23(4), pages 821-837, December.
  2. Ari, Ali, 2012. "Early warning systems for currency crises: The Turkish case," Economic Systems, Elsevier, vol. 36(3), pages 391-410.
  3. Irina Bunda, 2005. "Un modèle de crises jumelles inspiré de la crise asiatique," Revue économique, Presses de Sciences-Po, vol. 56(4), pages 903-937.
  4. Irina Bunda, 2005. "Un modèle de crises jumelles inspiré de la crise asiatique," Post-Print halshs-00424464, HAL.
  5. Hesse, Heiko, 2007. "Monetary policy, structural break and the monetary transmission mechanism in Thailand," Journal of Asian Economics, Elsevier, vol. 18(4), pages 649-669, August.

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