Understanding Financial Crises
Franklin Allen and Douglas Gale
Clarendon Lectures in Finance
June 9-11, 2003
1
Lecture 3
Bubbles and Crises
Franklin Allen
University of Pennsylvania
June 11, 2003
http://finance.wharton.upenn.edu/~allenf/
2
Introduction



In the previous lectures fundamental driven
crises were caused by low asset returns or high
liquidity demand
These events are often associated with the
bursting of bubbles
Kindleberger (1978) suggests that such bubbles
are often driven by an expansion of money and
credit
3
Can bubbles exist?
Historical bubbles
 Tulipmania 1635
 South Sea Bubble 1720
 Wall Street Crash of 1929
Recent bubbles
 Japan late 1980’s
 Scandinavia early 1990’s
 The technology bubble late 1990’s
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What is a bubble?



Standard models of asset pricing assume
people invest with their own money
We call the price of an asset in this
benchmark case is the "fundamental"
We say a bubble occurs when the price of
an asset rises above this fundamental
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Can bubbles be rational?
Infinite horizon bubbles


Possibility of bubbles: Samuelson (1958),
Blanchard and Watson (1982), Tirole (1985)
Rarity of bubbles in standard general equilibrium
models: Santos and Woodford (1997)
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Finite horizon bubbles


Ruling out bubbles with symmetric information:
Tirole (1982)
Bubbles as market failures due to asymmetric
information


Agency problems: Allen and Gorton (1993), Allen and
Gale (2000)
Lack of common knowledge: Allen, Morris and
Postlewaite (1993), Morris, Postlewaite and Shin
(1995), Brunnermeier (2001), Allen, Morris and Shin
(2003)
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A model of rational bubbles

Allen and Gale (2000) assume the people who make investment
decisions do so with borrowed money

Lenders cannot observe the riskiness of projects so there is an

Borrowers prefer risky projects because they receive the excess
above debt payments

They bid the prices of risky projects above their fundamentals and
there is a bubble

The more money and credit that is available the higher that prices
are bid
agency problem
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Two assets:
Safe asset:
(variable supply)
Risky asset
(fixed supply)
t=0
1
1 unit
costs P
1
1.5
6 w. pr. 0.25
1 “ “ 0.75
ER = 2.25
All investors are risk neutral
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The fundamental

Investors have wealth 1 and invest own money

Equating marginal returns
2.25 = 1.5
PF
1
PF = 2.25 = 1.5
1.5
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Intermediated case



Investors have no wealth of their own
They can borrow 1 at date 0 and repay
1.33 at date 1 if they can
Lenders can’t observe how loans are
invested
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Can P = 1.5 be equilibrium price?
Borrow 1 and invest in safe asset
RSafe = 1.5 – 1.33 = 0.17
Borrow 1 to buy 1/1.5 units of risky asset
RRisky = 0.25( 1 x 6–1.33) + 0.75x0 = 0.67 > 0.17
1.5
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What is the equilibrium P?

Since risky asset is in fixed supply, P will
be bid up until returns are equated
0.25( 1 x 6 – 1.33) + 0.75 x 0 = 1.5 – 1.33
P
P=3
 There’s a bubble since P = 3 > PF = 1.5
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
The more risk there is the greater is the risk
shifting and the larger the bubble

Default and a financial crisis occurs in this model
when the return on the risky asset is low


Risk shifting can occur in equilibrium provided
there is a spread between the rate depositors
receive and the rate the bank lends at so
competitive banks earn zero profits
The bank’s depositors bear the costs of the
agency problem and this requires markets are
segmented to be possible in equilibrium
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Credit and interest rates


The central bank sets credit B
The interest rate r is equal to the marginal
product of capital f’(B-P)
r = f’(B-P)

So the central bank controls r
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Pricing equation is now
0.25( 1 x 6 – f’(B-P)) + 0.75 x 0 = 0
P
With f(x) = 3x0.5 it can be shown
P(B) = 8(- 1 + (1+0.25B)0.5)
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Fundamental pricing equation
PF = 2.25
f’(B-PF)
PF(B) = -1.125 + 0.75(2.25 + 4B)0.5
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Credit and Asset Prices
7
6
5
4
P
P
PF
3
2
1
0
0
2
4
6
8
10
B
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Financial risk


The model can be developed to consider the
dynamic relationship between the amount of
credit available to investors and asset prices
What is meant by financial risk?

The amount of credit and hence interest rates are
taken as random variables by investors and this
uncertainty leads to uncertainty in asset prices
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t=0
Level of credit
= B0
1
Random level
of credit = B1
2
Asset in fixed
supply pays R
P(B1) random
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
Initially investors must anticipate the
amount of credit at the subsequent date
since this determines asset prices at the
subsequent date


If credit turns out to be too low asset prices
will not be high enough for loans to be repaid
and default will occur
Risk results from uncertainty about credit and
so is financial
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

The risk shifting effect operates for
financial risk in the same way as it does
for real risk so there can again be a
bubble
The possibility of credit expansion over a
period of years may create a great deal of
uncertainty about how high the bubble
may go and when it may collapse
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Policies to prevent bubbles
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The level and volatility of credit are important in
the determination of asset prices
Governments and central banks should avoid
unnecessary expansion in the level of credit and
uncertainty about the path of credit expansion
Financial liberalization is particularly risky
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Policies to minimize after-effects
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Financial problems of the banking sector spill
over into the real economy because of debt
overhang and inefficient liquidation
Effective solution in
Norway, Sweden
Ineffective solution in
Japan
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Post-bubble debt overhang



Ineffective policies to eliminate banking sector
problem may lead to large government debt as
in Japan
This government debt in itself becomes the
problem
How have large debt overhangs been eliminated
in the past?
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Prolonged growth

Britain after Napoleonic Wars
Extended period of moderate inflation

Britain after mid 1950’s
Burst of hyperinflation

Austria after WW1 and Japan after WW2
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Extended hyperinflation

Germany after WW1 (Weimar inflation)
Default

Germany after WW2
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The future

What will happen in Japan?
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