FIRE-SALE FDI Picture Mom, Dad, and the kids in an upper-middle-class Asian family in 10 years'time: After loading up with cash at the corner Citibank, they drive off to Walmart and fill the trunk of their Ford with the likes of Fritos and Snickers. On the way home, they stop at the american-owned Cineplex to catch the latest Disney movie, paying with their Visa card. In the evening, after putting the kids bed, Mom and Dad argue furiously about whether to invest in a Fidelity mutual fund or in a life insurance policy issued by American International Group OK, it's a bit silly, and was meant to be: when The New York Times painted this portrait in early 1998, it was a deliberate caricature. Nonetheless, it drew attention to a real phenomenon: the Asian financial crisis, although marked by massive flight of short-term capital and large-scale sell-offs of foreign equity holdings, has at the same time been accompanied by a wave of inward direct investment. This inward investment to some extent reflects policy changes, as Asian governments, under pressure from the IMF and in any case desperate for cash, have dropped old policies unfavorable to foreign ownership But it also reflects the perception of many multinational firms that they can now buy Asian companies and assets at fire-sale prices A similar, though probably less marked, boom in inward direct investment took place in Latin America, especially Mexico, during 1995; so we can, at least preliminarily, regard the nexus of crises, fire sales, and surging foreign direct investment as an empirical regularity. As such, it raises several interesting questions 1. Why should direct investment surge at a time when foreign capital in general is fleeing a country? What does this tell us about the nature of such crises? 2. Is the transfer of control that is associated with foreign ownership appropriate under these circumstances? That is, loosely speaking, are foreign corporations taking over control of domestic enterprises because they have special competence, and can therefore run them better, or simply because they have cash and the locals do not? 3. Does the fire sale of domestic firms and their assets represent a burden to the afflicted countries over and above the cost of the crisis itself? (This question is likely to be raised with considerable force if the nationalistic backlash in Asia, which is clearly present although so far still surprisingly muted, becomes a more important aspect of the situation. "We must realize the great danger facing our country", Malaysia's Prime Minister Mahathir has already warned. "If we are not careful we will be recolonized. )Or is the ability to sell firms to foreigners, on the contrary, a mitigating factor in the crisis? These are all, I believe, relatively novel questions. as already noted, the phenomenon of fire-sale was widely regarded as superior to that of the West. Moreover, the Asian crisis -to a far greater ad FDI"was indeed present in earlier crises; but it has become far more prominent this time because o the scale of the Asian crisis, the extraordinary collapse of asset values, and-perhaps most import the abruptness of our re-evaluation of an economic and corporate system that just a few months extent than the Latin crisis of 1995- has led to the creation of a set of"new wave crisis models that seem better suited to the discussion of direct investment than the traditional currency crisis literature
FIRE-SALE FDI "Picture Mom, Dad, and the kids in an upper-middle-class Asian family in 10 years' time: After loading up with cash at the corner Citibank, they drive off to Walmart and fill the trunk of their Ford with the likes of Fritos and Snickers. On the way home, they stop at the American-owned Cineplex to catch the latest Disney movie, paying with their Visa card. In the evening, after putting the kids to bed, Mom and Dad argue furiously about whether to invest in a Fidelity mutual fund or in a life insurance policy issued by American International Group." OK, it's a bit silly, and was meant to be: when The New York Times painted this portrait in early 1998, it was a deliberate caricature. Nonetheless, it drew attention to a real phenomenon: the Asian financial crisis, although marked by massive flight of short-term capital and large-scale sell-offs of foreign equity holdings, has at the same time been accompanied by a wave of inward direct investment. This inward investment to some extent reflects policy changes, as Asian governments, under pressure from the IMF and in any case desperate for cash, have dropped old policies unfavorable to foreign ownership. But it also reflects the perception of many multinational firms that they can now buy Asian companies and assets at fire-sale prices. A similar, though probably less marked, boom in inward direct investment took place in Latin America, especially Mexico, during 1995; so we can, at least preliminarily, regard the nexus of crises, fire sales, and surging foreign direct investment as an empirical regularity. As such, it raises several interesting questions: 1. Why should direct investment surge at a time when foreign capital in general is fleeing a country? What does this tell us about the nature of such crises? 2. Is the transfer of control that is associated with foreign ownership appropriate under these circumstances? That is, loosely speaking, are foreign corporations taking over control of domestic enterprises because they have special competence, and can therefore run them better, or simply because they have cash and the locals do not? 3. Does the fire sale of domestic firms and their assets represent a burden to the afflicted countries, over and above the cost of the crisis itself? (This question is likely to be raised with considerable force if the nationalistic backlash in Asia, which is clearly present although so far still surprisingly muted, becomes a more important aspect of the situation. "We must realize the great danger facing our country", Malaysia's Prime Minister Mahathir has already warned. "If we are not careful we will be recolonized." ) Or is the ability to sell firms to foreigners, on the contrary, a mitigating factor in the crisis? These are all, I believe, relatively novel questions. As already noted, the phenomenon of "fire- sale FDI" was indeed present in earlier crises; but it has become far more prominent this time because of the scale of the Asian crisis, the extraordinary collapse of asset values, and - perhaps most important - the abruptness of our re-evaluation of an economic and corporate system that just a few months ago was widely regarded as superior to that of the West. Moreover, the Asian crisis - to a far greater extent than the Latin crisis of 1995 - has led to the creation of a set of "new wave" crisis models that seem better suited to the discussion of direct investment than the traditional currency crisis literature
This paper, then, has three purposes. The first is simply to draw attention to the phenomenon of fire- ale FDI, and to stimulate discussion of what is likely to become a major economic and political issue in the coming years. The second is to indicate, in a preliminary way, how this phenomenon might emerge in the context of alternative crisis models. The third is to examine the welfare implications of crisis-induced sales of domestic assets to foreign firms, and in particular to ask how those mplications depend on our diagnosis of the crisis itself. 1. The fire sale: what is the evidence? At the time of writing hard statistical evidence of a surge in FDI into Asia was not yet available However, even a quick search of news databases turns up a plethora of anecdotes about foreign purchases of Asian firms-actual, impending, or potential -especially in South Korea. Recent titles of articles in the financial press include" Korean companies are looking ripe to foreign buyers"(New York Times, Dec 27), "Some U.S. companies see fire sale in South Korea"(Los Angeles Times, Jan 25), "Some companies jump into Asia's fire sale with both feet"(ouch! )(Chicago Tribune, Jan. 18) and"While some count their losses in Asia, Coca-Cola's chairman sees opportunity"(Wall Street Journal, feb. 6). The latter article described Coke's buyout of its Korean bottling partner, as well as its increased stake in its Thai operations. Other reported deals in prospect or under negotiation included General Motors was reported in January to be considering buying stakes in South Korean manufacturers of both automobiles and parts, while Ford was reported to be planning to increase its stake in Kia motors Seoul bank and Korea first bank were supposedly likely to be auctioned off to foreign bidders procter gamble purchased a majority share of Ssanyong Paper Co, a producer of sanitary napkins, diapers, and kitchen towels Royal Dutch Shell was negotiating to buy Hanwha Group's oil refining company; the group had already sold its half of a joint venture in chemicals to the German company BASF My favorite: "Michael Jackson is getting into the action, negotiating to acquire a ski resort from its owner, a bankrupt Korean underwear maker Aside from being entertaining, lists like this one serve to demonstrate an important point about the service companies to be buying up Asian counterparts: this is an area in which the United States has long been perceived to hold a substantial technological and managerial advantage, and has indeed been a focus of U.S. demands for liberalized trade and investment for precisely that reason. However until recently few would have argued that U.S. firms held a comparable advantage across the board in areas as diverse as auto manufacture and paper products. This indicates clearly that the source of the investment surge must lie in a change in conditions that affect all industries, namely the financial situation In a proximate sense there is, of course, no mystery about that change in conditions. In 1997 South
This paper, then, has three purposes. The first is simply to draw attention to the phenomenon of firesale FDI, and to stimulate discussion of what is likely to become a major economic and political issue in the coming years. The second is to indicate, in a preliminary way, how this phenomenon might emerge in the context of alternative crisis models. The third is to examine the welfare implications of crisis-induced sales of domestic assets to foreign firms, and in particular to ask how those implications depend on our diagnosis of the crisis itself. 1. The fire sale: what is the evidence? At the time of writing hard statistical evidence of a surge in FDI into Asia was not yet available. However, even a quick search of news databases turns up a plethora of anecdotes about foreign purchases of Asian firms - actual, impending, or potential - especially in South Korea. Recent titles of articles in the financial press include "Korean companies are looking ripe to foreign buyers" (New York Times, Dec. 27), "Some U.S. companies see fire sale in South Korea" (Los Angeles Times, Jan. 25), "Some companies jump into Asia's fire sale with both feet" (ouch!) (Chicago Tribune, Jan. 18), and "While some count their losses in Asia, Coca-Cola's chairman sees opportunity" (Wall Street Journal, Feb. 6). The latter article described Coke's buyout of its Korean bottling partner, as well as its increased stake in its Thai operations. Other reported deals in prospect or under negotiation included: - General Motors was reported in January to be considering buying stakes in South Korean manufacturers of both automobiles and parts, while Ford was reported to be planning to increase its stake in Kia Motors. - Seoul Bank and Korea First Bank were supposedly likely to be auctioned off to foreign bidders. -Procter & Gamble purchased a majority share of Ssanyong Paper Co., a producer of sanitary napkins, diapers, and kitchen towels. - Royal Dutch Shell was negotiating to buy Hanwha Group's oil refining company; the group had already sold its half of a joint venture in chemicals to the German company BASF. - My favorite: "Michael Jackson is getting into the action, negotiating to acquire a ski resort from its owner, a bankrupt Korean underwear maker." Aside from being entertaining, lists like this one serve to demonstrate an important point about the new surge of acquisitions: it is very widely spread across industries. It is one thing for U.S. financialservice companies to be buying up Asian counterparts: this is an area in which the United States has long been perceived to hold a substantial technological and managerial advantage, and has indeed been a focus of U.S. demands for liberalized trade and investment for precisely that reason. However, until recently few would have argued that U.S. firms held a comparable advantage across the board, in areas as diverse as auto manufacture and paper products. This indicates clearly that the source of the investment surge must lie in a change in conditions that affect all industries, namely the financial situation. In a proximate sense there is, of course, no mystery about that change in conditions. In 1997 South
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 was
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 "firstgeneration" 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
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 working
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 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
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 once
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 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