Academic journal article Economic Perspectives

Understanding the Asian Crisis: Systemic Risk as Coordination Failure

Academic journal article Economic Perspectives

Understanding the Asian Crisis: Systemic Risk as Coordination Failure

Article excerpt

Introduction and summary

The vast array of financial regulations in the United States and other developed economies is justified largely as a way of protecting the public from the dangers of systemic risk or systemic crisis in financial markets. Even the title of a recent General Accounting Office report on financial derivative regulation ("Financial derivatives: Actions needed to protect the financial system" [GAO, 1994]) and images in the popular press (a close-up of a snake with jaws wide open on the cover of Fortune magazine) appeal to our fear of systemic risk. While many different (and often mutually contradictory) characterizations of systemic risk have been proposed, it is somewhat disturbing that we lack a consensus as to what, precisely, systemic risk is.

In its most general usage, the term systemic crisis describes a shock to the financial system that impairs crucial functions of the system, such as asset valuation, credit allocation, and payments.(1) This characterization, however, is not too helpful. What sort of mechanism can result in this sort of impairment? Economists do not agree. Proposed answers include: irrational piling-on of debt;(2) moral hazard induced by mispriced government-provided deposit insurance;(3) complex relationships among counterparties;(4) an unwillingness of dealers to trade;(5) a failure of the central bank to provide liquidity as needed;(6) unpredictable adverse shocks that come from outside the financial sector;(7) and bank runs.(8) Regardless of which characterization one prefers, a satisfactory theory of systemic risk requires a fully articulated, internally consistent economic model. A rigorous economic model may leave uncertainty as to how the model maps to reality, but there can be no uncertainty about what is meant within the context of the model itself.

While economists may disagree as to the causes and nature of systemic risk, there have been specific events in history that are generally recognized as examples of systemic crisis. The most recent such event is the Asian crisis that began in mid-1997. This crisis displays certain textbook characteristics generally associated with systemic crisis: It appeared to originate in financial markets; it displayed contagion, with problems in one country seeming to induce crises in other countries; there was clear evidence of confidence loss by investors; there were substantial real costs in economic output; and the crisis clearly called for a policy response. One aspect of the Asian crisis that is more difficult to explain using standard theories is that it seemed to emerge almost spontaneously. Although, with hindsight, one can point to conditions that may have made some East Asian economies vulnerable to economic disturbance, the crisis was not forecasted by knowledgeable observers, nor was it triggered by any shocks commensurate with the scale of the upheaval.

I argue in this article that the standard neoclassical model commonly used in economic analysis is poorly suited to explain the sort of crisis in which a small impulse induces a large change in economic performance. Rather, the Asian crisis is best explained as an example of coordination failure. Suppose the economic performance of a country (or a firm, industry, or financial market) depends on large numbers of investors being willing to provide funds. If it is generally believed that other investors will withhold funds, it is rational for any given investor to refrain from investing. Thus, these beliefs become self-fulfilling. This represents a coordination failure because everyone would be better off if all investors provided funds to the affected country. Unfortunately, there is no way to coordinate investor actions in this way.

In this article, I formalize this notion of coordination failure in a simple static model. My model implies that, as in the Diamond-Dybvig (1983) model of bank runs, some credible insurance mechanism is necessary to avoid costly coordination failure. …

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