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The Credit Crisis: Conjectures about Causes and Remedies

The Credit Crisis: Conjectures about Causes and Remedies American Economic Review: Papers & Proceedings 2009, 99:2, 606–610 http://www.aeaweb.org/articles.php?doi=10.1257/aer.99.2.606 By Douglas W. Diamond and Raghuram G. Rajan* What caused the financial crisis that is sweeping across the world? What keeps asset prices and lending depressed? What can be done to remedy matters? While it is too early to arrive at definite answers to these questions, it is certainly time to offer informed conjectures, and these will be the focus of our paper. There is some consensus on the proximate causes of the crisis: (i) the US financial sector misallocated resources to real estate, financed through the issuance of exotic new financial instruments; (ii) a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets; (iii) these investments were largely financed with short-term debt. Let us first dig deeper into the more fundamental reasons for these proximate causes. I. Misallocation of Investment This is a crisis born in some ways of previous financial crises, which swept through the emerging markets in the late 1990s: East Asian economies collapsed, Russia defaulted, and Argentina, Brazil, and Turkey faced severe stress. In response to these crises, emerging markets became far more circumspect about http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Review American Economic Association

The Credit Crisis: Conjectures about Causes and Remedies

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References (29)

Publisher
American Economic Association
Copyright
Copyright © 2009 by the American Economic Association
Subject
Papers
ISSN
0002-8282
DOI
10.1257/aer.99.2.606
Publisher site
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Abstract

American Economic Review: Papers & Proceedings 2009, 99:2, 606–610 http://www.aeaweb.org/articles.php?doi=10.1257/aer.99.2.606 By Douglas W. Diamond and Raghuram G. Rajan* What caused the financial crisis that is sweeping across the world? What keeps asset prices and lending depressed? What can be done to remedy matters? While it is too early to arrive at definite answers to these questions, it is certainly time to offer informed conjectures, and these will be the focus of our paper. There is some consensus on the proximate causes of the crisis: (i) the US financial sector misallocated resources to real estate, financed through the issuance of exotic new financial instruments; (ii) a significant portion of these instruments found their way, directly or indirectly, into commercial and investment bank balance sheets; (iii) these investments were largely financed with short-term debt. Let us first dig deeper into the more fundamental reasons for these proximate causes. I. Misallocation of Investment This is a crisis born in some ways of previous financial crises, which swept through the emerging markets in the late 1990s: East Asian economies collapsed, Russia defaulted, and Argentina, Brazil, and Turkey faced severe stress. In response to these crises, emerging markets became far more circumspect about

Journal

American Economic Review – American Economic Association

Published: May 1, 2009

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