Toan Phan (University of North Carolina, Chapel Hill)

“Toxic Asset Bubble”

Abstract

We show that toxic (i.e., welfare reducing) asset bubbles can emerge in a standard framework of stochastic rational bubble if there is financial friction. The friction generated by limited liability and non-contingent debt contracts prevents banks from fully internalizing the bubble’s risk of collapse. Hence boom-bust episodes involving excessively risky bubbles can emerge in equilibrium. We show that a policy of “leaning against the bubble” can improve social welfare. Second, we generalize the model to two large open economies. The global model shows that an emerging economy can “outsource” a toxic bubble to a developed economy through global financial intermediation. Hence, a toxic bubble can emerge in the developed economy, where there is no dynamic inefficiency (which is usually a necessary condition for bubbles). The model formalizes the idea that a “savings glut” coming from emerging economies to the United States fueled the boom of a subprime mortgage bubble. The model provides a tractable framework for policy analysis regarding optimal bubble policies in open economies.