Delayed Crises and Slow Recoveries (Online Seminar)
Building on the seminal work of Abreu and Brunnermeier (2002, 2003) on asynchronous awareness, this paper formalizes credit-driven financial crises as a Keynes’ game of musical chairs in a textbook stochastic growth model (RBC), speaking to Minsky’s financial instability hypothesis in a rational expectations framework. In our model economy, banks can operate in two types of business la Minsky’s narratives. They are sequentially aware of the deterioration of fundamentals of the speculative business and decide whether to continue credit extension in that business or liquidate capital and move into the traditional business. However, because individual banks face uncertainty about how many of their peers have been aware, they rationally choose to extend credit in the speculative business for a longer time than is socially optimal, leading to an over-delayed crisis and consequently more banks being caught by the crisis. This in turn renders the financial crisis more severe and the subsequent economic recovery slower. Within a standard textbook macroeconomic growth model, our paper demonstrates that asynchronous awareness can be a powerful propagation mechanism for credit expansion in generating rich dynamics of economic booms, slowdowns, crashes, and recoveries.