And then the bubble burst. The mechanism of crisis, I suggest, involved that same circular process in reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to cease operations, leading to further asset deflation. This circularity, in turn, can explain both the remarkable severity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis which in turn helps us understand the phenomenon of contagion between economies with few visible economic links The story can be illustrated using a highly simplified example, in which there exists a class of owners of financial intermediaries("Ministers' nephews")who are able to borrow money at the safe interest rate-because lenders perceive them as being backed by an implicit government guarantee -and invest that money in risky assets. For the sake of simplicity, the moral hazard involved in this situation is pushed to an extreme by assuming that the owners of intermediaries are not obliged to put any of their own capital at risk; there are many Minsters'nephews, competing to buy risky asset In such a worst-case scenario for moral hazard, the owner of an intermediary will view investing in an asset as profitable if there is any state of nature in which that asset yields a return greater than the safe interest rate. At the same time, competition among intermediaries will eliminate any economic rofits. The result must therefore be that the prices of assets are driven to their "Pangloss values hat they would be worth based, not on the expected outcome, but what would happen if we lived in the best of all possible worlds To see the implications of this setup, consider first a one-stage game, in which intermediaries initially compete to buy an asset with uncertain future payoff -call it land- and then learn what that payoff is In particular, consider land that may yield a present value of future rent of either 100(with probability 1/)or 25(with probability 2/3). In the absence of moral hazard, risk-neutral investors would be willing to pay a price of 50, the expected value of the land. In the extreme moral hazard gime we have described, however, each Minister's nephew will realize a profit in the favorable state of nature as long as the price is less than 100, and will simply walk away from the intermediary if the state of nature is unfavorable. So competition among the nephews will drive the price to its Pangloss Next consider a two-stage game. In period 1 land is bought. In period 2 initial rents are revealed, and without changing the substance, if we suppose both that rents are iid (specifically 25 with probability 2/3, 100 with probability 1/3)and that the safe interest rate is zero In an undistorted economy we can solve backwards for the price. The expected rent in period 3, and therefore the price of land purchased at the end of period 2, 152(50)plus the expected price at which 50. The expected return on land purchased in period 1 is therefore the expected rent in period 2 it can be sold(also 50), for a first-period price of 100. This is also, of course, the total expected rent over the two periods (In this example, the price of land declines over time, from 100 to 50, even in the undistorted case. This is merely an artifact of the finite horizon and should simply be regarded as a baseline) Now suppose that intermediaries are in a position to borrow with guarantees. Again workingAnd then the bubble burst. The mechanism of crisis, I suggest, involved that same circular process in reverse: falling asset prices made the insolvency of intermediaries visible, forcing them to cease operations, leading to further asset deflation. This circularity, in turn, can explain both the remarkable severity of the crisis and the apparent vulnerability of the Asian economies to self-fulfilling crisis - which in turn helps us understand the phenomenon of contagion between economies with few visible economic links. The story can be illustrated using a highly simplified example, in which there exists a class of owners of financial intermediaries ("Ministers' nephews") who are able to borrow money at the safe interest rate - because lenders perceive them as being backed by an implicit government guarantee - and invest that money in risky assets. For the sake of simplicity, the moral hazard involved in this situation is pushed to an extreme by assuming that: - the owners of intermediaries are not obliged to put any of their own capital at risk; - there are many Minsters' nephews, competing to buy risky assets. In such a worst-case scenario for moral hazard, the owner of an intermediary will view investing in an asset as profitable if there is any state of nature in which that asset yields a return greater than the safe interest rate. At the same time, competition among intermediaries will eliminate any economic profits. The result must therefore be that the prices of assets are driven to their "Pangloss values": what they would be worth based, not on the expected outcome, but what would happen if we lived in the best of all possible worlds. To see the implications of this setup, consider first a one-stage game, in which intermediaries initially compete to buy an asset with uncertain future payoff - call it land - and then learn what that payoff is. In particular, consider land that may yield a present value of future rent of either 100 (with probability 1/3) or 25 (with probability 2/3). In the absence of moral hazard, risk-neutral investors would be willing to pay a price of 50, the expected value of the land. In the extreme moral hazard regime we have described, however, each Minister's nephew will realize a profit in the favorable state of nature as long as the price is less than 100, and will simply walk away from the intermediary if the state of nature is unfavorable. So competition among the nephews will drive the price to its Pangloss value of 100. Next consider a two-stage game. In period 1 land is bought. In period 2 initial rents are revealed, and land may be resold. Finally, in period 3 a second round of rents are revealed. It simplifies matters, without changing the substance, if we suppose both that rents are iid (specifically 25 with probability 2/3, 100 with probability 1/3) and that the safe interest rate is zero. In an undistorted economy we can solve backwards for the price. The expected rent in period 3, and therefore the price of land purchased at the end of period 2, is 50. The expected return on land purchased in period 1 is therefore the expected rent in period 2 (50) plus the expected price at which it can be sold (also 50), for a first-period price of 100. This is also, of course, the total expected rent over the two periods. (In this example, the price of land declines over time, from 100 to 50, even in the undistorted case. This is merely an artifact of the finite horizon and should simply be regarded as a baseline). Now suppose that intermediaries are in a position to borrow with guarantees. Again working