Korea's currency lost half its value against the dollar, and its stock market lost 40 percent of its value in domestic currency. Thus the price of South Korean corporations to foreign buyers in effect fell by 70 percent, in some cases producing what appeared to be spectacular bargains(Korean Air Lines with a fleet of more than 100 jets, had a market capitalization at end-1997 of $240 million, roughly the price of two Boeing 747s-although any buyer would also have acquired its $5 billion debt) Moreover, heavily indebted corporations, facing a credit crunch, were desperate to sell off factories and subsidiaries to raise cash The more difficult question, however, is to explain why the prices of assets should have fallen so much, so suddenly -which comes down to the question of how to explain the crisis itself. As we will see, our assessment of the apparent surge in foreign direct investment depends in some ways on our model of the crisis The next step is therefore to set out two alternative(though not necessarily mutually exclusive) models of the Asian financial crisis; once we have these models under our belt we can try to see what they say about foreign direct investment 2. Modeling the crisis I: Moral hazard and asset deflation One thing that quickly became apparent in the asian crisis was that the depth and scope of the calamity put it outside the range of what traditional speculative-attack models- whether of the"first generation"type developed in the late 70s and early 80s(Krugman 1979, Flood and Garber 1984)or the"second-generation"type that became popular after the European currency attacks of 1992 (Obstfeld 1994)-could explain. a heavy majority of the theoretical efforts to make sense of the crisis focus on the role of financial intermediaries; indeed, many of us believe that as a first cut it may actually be useful to ignore exchange rates and monetary aspects entirely, focussing on the demand for and pricing of real asset Within this agreed-on focus on the financial system, very recently much- though not all -discussion of the Asian crisis seems to have started to cluster around an approach that stresses the role of implicit guarantees in producing moral hazard, of moral hazard in producing over-borrowing, and then of the implosion of the unsound financial system thus created, producing a self-reinforcing collapse of asset values. The moral hazard-overborrowing view was emphasized in a series of initially under-appreciated papers by McKinnon and Pill(especially McKinnon and Pill 1987). My own simplified exposition of how moral hazard can create overpricing of assets, and how an endogenous policy regime- in which implicit guarantees are maintained only as long as they do not prove too expensive- can cause self-fulfilling crisis(Krugman 1998a, b)seems, for the moment at least, to have provided the seed around which opinion has crystallized. As we will see, there are other possible models, which are by no means out of the running. However, it seems appropriate to begin with this canonical-model-of-the-minute, since it does offer one way to make sense of fire-sale FDi Here is how the story works The problem began with financial intermediaries-institutions whose liabilities were perceived as having an implicit government guarantee, but were essentiall unregulated and therefore subject to severe moral hazard problems. The excessive risky lending of these institutions created inflation -not of goods but of asset prices. The overpricing of assets was sustained in part by a sort of circular process, in which the proliferation of risky lending drove up the prices of risky assets, making the financial condition of the intermediaries seem sounder than it wasKorea's currency lost half its value against the dollar, and its stock market lost 40 percent of its value in domestic currency. Thus the price of South Korean corporations to foreign buyers in effect fell by 70 percent, in some cases producing what appeared to be spectacular bargains (Korean Air Lines, with a fleet of more than 100 jets, had a market capitalization at end-1997 of $240 million, roughly the price of two Boeing 747s - although any buyer would also have acquired its $5 billion debt). Moreover, heavily indebted corporations, facing a credit crunch, were desperate to sell off factories and subsidiaries to raise cash. The more difficult question, however, is to explain why the prices of assets should have fallen so much, so suddenly - which comes down to the question of how to explain the crisis itself. As we will see, our assessment of the apparent surge in foreign direct investment depends in some ways on our model of the crisis. The next step is therefore to set out two alternative (though not necessarily mutually exclusive) models of the Asian financial crisis; once we have these models under our belt we can try to see what they say about foreign direct investment. 2. Modeling the crisis I: Moral hazard and asset deflation One thing that quickly became apparent in the Asian crisis was that the depth and scope of the calamity put it outside the range of what traditional speculative-attack models - whether of the "first￾generation" type developed in the late 70s and early 80s (Krugman 1979, Flood and Garber 1984) or the "second-generation" type that became popular after the European currency attacks of 1992 (Obstfeld 1994) - could explain. A heavy majority of the theoretical efforts to make sense of the crisis focus on the role of financial intermediaries; indeed, many of us believe that as a first cut it may actually be useful to ignore exchange rates and monetary aspects entirely, focussing on the demand for and pricing of real assets. Within this agreed-on focus on the financial system, very recently much - though not all - discussion of the Asian crisis seems to have started to cluster around an approach that stresses the role of implicit guarantees in producing moral hazard, of moral hazard in producing over-borrowing, and then of the implosion of the unsound financial system thus created, producing a self-reinforcing collapse of asset values. The moral hazard-overborrowing view was emphasized in a series of initially under-appreciated papers by McKinnon and Pill (especially McKinnon and Pill 1987). My own simplified exposition of how moral hazard can create overpricing of assets, and how an endogenous policy regime - in which implicit guarantees are maintained only as long as they do not prove too expensive - can cause self-fulfilling crisis (Krugman 1998a,b) seems, for the moment at least, to have provided the seed around which opinion has crystallized. As we will see, there are other possible models, which are by no means out of the running. However, it seems appropriate to begin with this canonical-model-of-the-minute, since it does offer one way to make sense of fire-sale FDI. Here is how the story works: The problem began with financial intermediaries - institutions whose liabilities were perceived as having an implicit government guarantee, but were essentially unregulated and therefore subject to severe moral hazard problems. The excessive risky lending of these institutions created inflation - not of goods but of asset prices. The overpricing of assets was sustained in part by a sort of circular process, in which the proliferation of risky lending drove up the prices of risky assets, making the financial condition of the intermediaries seem sounder than it was