backward, at the end of period 2 they will be willing to pay the Pangloss value of third-period rent, 100. In period 1 they will be willing to pay the most they could hope to realize off a piece of land: the Pangloss rent in period 2, plus the Pangloss price of land at the end of that period. So the price of land with intermediation will be 200 in period 1-again, twice the undistorted price Our next step is to allow for the possibility of changes in the financial regime Let us continue to focus on our three-period economy, with random rents on land in periods 2 and 3 And let us also continue to assume that in the first period competition among intermediaries with guaranteed liabilities causes asset prices to be determined by Pangloss rather than expected returns However, let us now introduce the possibility that this regime may not last-that liabilities carried over from period 2 to period 3 might not be guaranteed As a first step, let ply posit that the regime change is exogenous-that from the point of view of investors there is simply some probability p that the government will credibly announce during period 2 that henceforth creditors of intermediaries are on their own(Perhaps this reflects the election of a reformist government that is no longer prepared to tolerate"crony capitalism",or perhaps the end of moral hazard is imposed by the International Monetary Fund) Again, we work backward, and consider the price of land in the second period. If liabilities of intermediaries are not guaranteed, then nobody will lend to them( the moral hazard will remain, but its burden would now fall on investors rather than on the government ). So intermediation will collapse, and the price of land will reflect only its expected return of 50. On the other hand, if intermediaries are guaranteed, the price will still be 100 What about the price of land in the first period? Investors now face two sources of uncertainty: they do not know whether the rent in the second period will be high or low, and they do not know whether the price of land in the second period will reflected expected values or Pangloss values. However, as long as there is competition among intermediaries in the first period, the price of land will once again be driven to a level that reflects the most favorable possible outcome: rents of 100 and a price of 100 So even though this is now a multi-period world in which everyone knows that disintermediation and a decline in asset prices is possible, current asset prices are still set as if that possibility does not exist Finally, let us ask what happens when the change in regime is endogenous In reality, of course, throughout Asia's arc of crisis there has indeed been a major change in financial regime. Finance companies have been closed, banks forced to curtail risky lending at best and close their doors at worst; even if the IMF were not insisting on financial housecleaning as a condition for aid, the days of cheerful implicit guarantees and easy lending for risky investment are clearly over for some time to come. But what provoked this change of regime? Not an exogenous change in economic philosophy: financial intermediaries have been curtailed precisely because they were seen to have lost a lot of mone This suggests that a more or less real istic way to model the determination of implicit guarantees is to suppose that they are available only until they have had to be honored (or more generally until the context of our three-period example, this criterion can be stated alternatively as the proposition p honoring them has turned out to be sufficiently expensive-the criterion used in Krugman 1998b) that creditors of financial intermediaries will be bailed out precisely oncebackward, at the end of period 2 they will be willing to pay the Pangloss value of third-period rent, 100. In period 1 they will be willing to pay the most they could hope to realize off a piece of land: the Pangloss rent in period 2, plus the Pangloss price of land at the end of that period. So the price of land with intermediation will be 200 in period 1 - again, twice the undistorted price. Our next step is to allow for the possibility of changes in the financial regime. Let us continue to focus on our three-period economy, with random rents on land in periods 2 and 3. And let us also continue to assume that in the first period competition among intermediaries with guaranteed liabilities causes asset prices to be determined by Pangloss rather than expected returns. However, let us now introduce the possibility that this regime may not last - that liabilities carried over from period 2 to period 3 might not be guaranteed. As a first step, let us simply posit that the regime change is exogenous - that from the point of view of investors there is simply some probability p that the government will credibly announce during period 2 that henceforth creditors of intermediaries are on their own. (Perhaps this reflects the election of a reformist government that is no longer prepared to tolerate "crony capitalism"; or perhaps the end of moral hazard is imposed by the International Monetary Fund). Again, we work backward, and consider the price of land in the second period. If liabilities of intermediaries are not guaranteed, then nobody will lend to them (the moral hazard will remain, but its burden would now fall on investors rather than on the government). So intermediation will collapse, and the price of land will reflect only its expected return of 50. On the other hand, if intermediaries are guaranteed, the price will still be 100. What about the price of land in the first period? Investors now face two sources of uncertainty: they do not know whether the rent in the second period will be high or low, and they do not know whether the price of land in the second period will reflected expected values or Pangloss values. However, as long as there is competition among intermediaries in the first period, the price of land will once again be driven to a level that reflects the most favorable possible outcome: rents of 100 and a price of 100. So even though this is now a multi-period world in which everyone knows that disintermediation and a decline in asset prices is possible, current asset prices are still set as if that possibility does not exist. Finally, let us ask what happens when the change in regime is endogenous. In reality, of course, throughout Asia's arc of crisis there has indeed been a major change in financial regime. Finance companies have been closed, banks forced to curtail risky lending at best and close their doors at worst; even if the IMF were not insisting on financial housecleaning as a condition for aid, the days of cheerful implicit guarantees and easy lending for risky investment are clearly over for some time to come. But what provoked this change of regime? Not an exogenous change in economic philosophy: financial intermediaries have been curtailed precisely because they were seen to have lost a lot of money. This suggests that a more or less realistic way to model the determination of implicit guarantees is to suppose that they are available only until they have had to be honored (or more generally until honoring them has turned out to be sufficiently expensive - the criterion used in Krugman 1998b). In the context of our three-period example, this criterion can be stated alternatively as the proposition that creditors of financial intermediaries will be bailed out precisely once