Are Crises Inevitable?

Recessions and other crises seem to occur without any large exogenous shocks. One theory is that this is due to strategic complementarities: the incentive to invest is stronger if others are expected to invest. If, in addition, each investor observes a slightly noisy signal of the true fundamentals, a crisis occurs whenever fundamentals fall below a certain threshold (Morris and Shin, AER 1998). However, this theory cannot explain recurrent crises: with drift or permanent shocks to fundamentals, the chance of a crisis falls quickly over time. Our main result is that rent seeking by the supplier of a critical input can reverse this result, leading to a constant crisis risk. Intuitively, past improvements in fundamentals simply lead to higher input prices, leaving the economy perpetually vulnerable to a negative shock. The full text of this paper can be downloaded from http://www.econ.iastate.edu/faculty/frankel/gg.pdf. ∗Department of Economics, Iowa State University, Ames, IA 50011, [email protected]. I am grateful to Drew Fudenberg for helpful comments.