Managing Financial Crises

In this paper, we revisit the question of how to manage financial crises using the framework proposed by Bianchi and Mendoza (2018). We show that this model economy exhibits a multiplicity of constrained-efficient equilibria, which arises because the private shadow value of collateral influences the forward-looking asset price. Among these equilibria, the specific one studied in Bianchi and Mendoza (2018) can be implemented using a tax/subsidy on debt alone. In that case, both the ex ante tax and ex post subsidy are quantitatively important for welfare under the optimal time-consistent policy. Limiting either component can lead to a welfare loss relative to the unregulated competitive equilibrium, highlighting the complementarity between crisis prevention and crisis resolution tools. We also show that, under certain conditions, all Pareto-dominant constrained-efficient equilibria entail the unconstrained allocation chosen by a social planner subject to the country budget constraint, and this allocation can be implemented with purely ex post policies.