Financial Crises, Coordination Failures and Disasters

Why do some financial crises lead to macroeconomic disasters, while others barely affect thereal economy? How should policy makers deal with such extreme events? This paper proposes a model to study unusually deep financial... [ view full abstract ]

Why do some financial crises lead to macroeconomic disasters, while others barely affect the

real economy? How should policy makers deal with such extreme events? This paper proposes a model to study unusually deep financial crises. Disaster episodes arise as the consequence of demand-driven coordination failures on the productive sector, and weak balance sheets on the financial sector. There is an endogenous dynamic feedback between intermediaries’ balance sheets and coordination. Coordination failures alone have small effects, but once one takes into account the dynamic feedback from the financial sector, they have a large negative impact on asset prices, investment and welfare, even if the economy is in good times and they rarely happen. Macroprudential policies that increase intermediaries’ returns during disasters greatly improve welfare, growth and financial stability, almost mitigating the negative effects of coordination
failures.