Government Guarantees, Investment, and Vulnerability to Financial Crises

Abstract

The paper presents a new model of the East Asian crisis which combines three elements-moral hazard, investment collapse, and multiple equilibria-in a single account. The study locates the causes of the crisis in poor financial regulation, highly leveraged financial institutions, and implicit guarantees to the financial sector. The model has a unique long-run equilibrium with overinvestment. But in the short run, in which the capital stock is fixed, there may be multiple equilibria. In a crisis the government is forced to renege on its guarantees; the effect is a rapid reversal of foreign capital flows. Copyright Blackwell Publishing Ltd 2003.

Capital Account Convertibility, Poor Developing Countries, and International Financial Architecture

“…This is because, once the government is forced to renege, it is difficult to see how it can credibly promise similar guarantees in the future. But without such guarantees much of the investment undertaken will become unprofitable, and funds will be withdrawn from the country (see Corbett et al, 1999;Irwin and Vines, 2000).…”

Monetary Policy, Structural Break, And The Monetary Transmission Mechanism In Thailand

“…Similarly, according toWarr and Vines (2003), Thailand's investment boom and bust mainly contributed to the increased vulnerability of the economy.6 There is a huge literature on modelling the Asian currency and financial crisis. SeeKrugman (1999),Masson (1999),Agenor, Miller, Vines, and Weber (1999),Irwin and Vines (2003) amongst others Krugman (1999). attempts to explain the Asian crisis from deteriorating firms' balance sheets and moral hazard problems whereasMasson (1999) postulates a story in which contagion was the predominant factor.…”

“…attempts to explain the Asian crisis from deteriorating firms' balance sheets and moral hazard problems whereasMasson (1999) postulates a story in which contagion was the predominant factor. In contrast,Irwin and Vines (2003) combine various strands of the so-called 'third generation models' into a coherent framework that involves investment collapse, moral hazard problems, and multiple equilibria. Finally,Agenor et al (1999) provide a full conceptual, empirical and theoretical account of the crisis.…”