LOOKING AT FINANCIAL CRISES IN THE EYE Some Basic Observations

The paper discusses frameworks in which the financial sector is at the eye of the storm. In that context, policies that do not repair the damage in the financial sector are, by necessity, second‐best. Actually, aggregate demand policies – emphasized in textbook Keynesian models – may be inferior to heterodox policies that rely on credit targeting. Moreover, based on salient characteristics of modern financial systems, the paper offers a rationale for the fact that many major financial crises appear to come from nowhere. An example is discussed in which the creation of asset‐backed securities may generate an asset price boom. However, asset‐backed securities are subject to runs that, as in Morris and Shin (1998), depend on unobservables. The run, in turn, provokes a crash in the attendant asset prices. The liquidity crisis could spill over to the real sector through a Sudden Stop in domestic credit and/or a sharp change in credit composition in favor of governments and large firms, and against small and medium‐size enterprises. Domestic credit Sudden Stop and sharp changes in credit composition are shown to be prominent features in financial crises, including the subprime. *This is a thoroughly revised version of a paper with the same main title circulated in November 2009. I am thankful to Ricardo Hausmann, Alejandro Izquierdo and Carmen Reinhart for their very useful comments; and to Ivan Khotulev and Rudy Loo‐Kung for research assistance.