Financial Crises and Government Interventions

We develop a model of financial crises with both a financial amplification mechanism, via frictional intermediation, and a role for sentiment, via time-varying beliefs about an illiquidity state. The model accounts for the entire crisis cycle, matching data on the frothy pre-crisis behavior of asset markets and credit, the sharp transition to a crisis where asset values fall, disintermediation occurs and output falls, and the slow postcrisis recovery in output. Both the intermediation and belief mechanism are essential to match the crisis cycle. However, modeling the belief variation via either a Bayesian or diagnostic model can match the broad patterns.

This paper studies the equilibrium effect of public liquidity on financial crises. Banks borrow from households via insured deposits and partially runnable debt, and suffer endogenous funding withdrawals from households in crises. Holding public liquidity alleviates banks' liquidity problems. In equilibrium, a larger public liquidity supply reduces crisis severity, expands bank lending, but crowds bank deposits and increases bank vulnerability to real shocks. The model quantitatively explains 40% of Treasury liquidity premium variations. Counterfactual analyses reveal that QE1 significantly improves output, 20 times larger than QE3. However, QE infinity during COVID-19 increases bank fragility to real shocks and reduces output.

A salient trend in crisis intervention has emerged in recent decades: Government and central banks offered funding directly to nonfinancial firms, bypassing banks and other credit intermediaries. We analyze the long-term consequences of such policies by focusing on firm quality dynamics. In a laissez-faire economy, firms with high productivity are more likely to survive crises than those with low productivity. The government funding support saves more firms but cannot be customized based on firm productivity, dampening the cleansing effect of crises. The policy distortion is self-perpetuating: A downward bias in firm quality distribution necessitates interventions of greater scale in future crises. Our mechanism is quantitatively important: we show that if policy makers ignore such distortionary effects on firm quality dynamics, the resultant credit intervention would almost double the optimal amount.