Douglas Gale

Bubbles and Crises

In recent financial crises a bubble, in which asset prices rise, is followed by a collapse and widespread default. Bubbles are caused by agency relationships in the banking sector. Investors use money borrowed from banks to invest in risky assets, which are relatively attractive because investors can avoid losses in low payoff states by defaulting on the loan. This risk shifting leads investors to bid up the asset prices. Risk can originate in both the real and financial sectors. Financial fragility occurs when positive credit expansion is insufficient to prevent a crisis.

Competition and Financial Stability

Competition policy in the banking sector is complicated by the necessity of maintaining financial stability. Greater competition may be good for (static) efficiency, but bad for financial stability. From the point of view of welfare economics, the relevant question is: what are the efficient levels of competition and financial stability? We use a variety of models to address this question and find that different models provide different answers. The relationship between competition and stability is complex: sometimes competition increases stability. In addition, in a second-best world, concentration may be socially preferable to perfect competition and perfect stability may be socially undesirable.

INFORMATION REVELATION AND STRATEGIC DELAY IN A MODEL OF INVESTMENT

The authors characterize the symmetric equilibria of an investment game with a pure informational externality. When the period length is very short, the game ends very quickly; with positive probability, an informational cascade (herding) causes an investment collapse. As the period length increases, the possibility of herding disappears. As the number of players increases, the rate of investment and the information flow are eventually independent of the number of players; adding more players simply increases the number who delay. In the limit, a period of low investment is followed by either an investment surge or a collapse. Copyright 1994 by The Econometric Society.

Financial Markets, Intermediaries, and Intertemporal Smoothing

In an overlapping generations economy with (incomplete) financial markets but no intermediaries, there is underinvestment in safe assets. In an economy with intermediaries and no financial markets, accumulating reserves of safe assets allows returns to be smoothed, nondiversifiable risk to be eliminated, and an ex ante Pareto improvement compared to the allocation in the market equilibrium to be achieved. In a mixed financial system, however, competition from financial markets constrains intermediaries so that they perform no better than markets alone.

Bayesian learning in social networks

Abstract We extend the standard model of social learning in two ways. First, we introduce a social network and assume that agents can only observe the actions of agents to whom they are connected by this network. Secondly, we allow agents to choose a different action at each date. If the network satisfies a connectedness assumption, the initial diversity resulting from diverse private information is eventually replaced by uniformity of actions, though not necessarily of beliefs, in finite time with probability one. We look at particular networks to illustrate the impact of network architecture on speed of convergence and the optimality of absorbing states. Convergence is remarkably rapid, so that asymptotic results are a good approximation even in the medium run.

A welfare comparison of intermediaries and financial markets in Germany and the US

Abstract There is wide variation in the structures of financial systems in different countries. We compare two polar extremes. In one, which we refer to as the ‘German model’, intermediaries predominate. In the second, which we refer to as the ‘U.S. model’, financial markets play the major role. Our objective is to contribute to a theoretical framework for the welfare analysis of comparative financial systems. The study is divided into two parts, which focus on financial services provided to households and firms, respectively. On the household side, we consider issues such as cross-sectional and intertemporal risk sharing, noise suppression and the provision of services. On the firm side, we consider information, financing, the market for corporate control, and diversity of opinion.

Financial Fragility, Liquidity and Asset Prices

We define a financial system to be fragile if small shocks have disproportionately large effects. In a model of financial intermediation, we show that small shocks to the demand for liquidity cause either high asset-price volatility or bank defaults or both. Furthermore, as the liquidity shocks become vanishingly small, the asset-price volatility is bounded away from zero. In the limit economy, with no shocks, there are many equilibria; however, the only equilibria that are robust to the introduction of small liquidity shocks are those with non-trivial sunspot activity.

What have we learned from social learning

Abstract Models of herd behavior and informational cascades often make strong assumptions about the information available to agents, the nature of the choices being made, the timing of decisions, and the symmetry of equilibrium. This note considers the robustness of some results from the literature on social learning and argues that the inefficiency of equilibrium in the presence of informational externalities and strategic delay may be the most important lesson of all.

Estimating ambiguity aversion in a portfolio choice experiment

We report a laboratory experiment that enables us to estimate parametric models of ambiguity aversion at the level of the individual subject. We use two main specifications, a “kinked” specification that nests Maxmin Expected Utility, Choquet Expected Utility, α-Maxmin Expected Utility, and Contraction Expected Utility and a “smooth” specification that nests the various theories referred to collectively as Recursive Expected Utility. Our subjects solved a series of portfolio-choice problems. The assets are Arrow securities corresponding to three states of nature, where the probability of one state is known and the remaining two are ambiguous. The sample exhibits considerable heterogeneity in preferences, as captured by parameter estimates. Nonetheless, there exists a strong tendency to equalize the demands for the securities that pay off in the ambiguous states, a feature more easily accommodated by the kinked specification than by the smooth specification. We also find that a large number of subjects are well described by the ambiguity-neutral Subjective Expected Utility model.

A walrasian theory of markets with adverse selection

The paper describes a Walrasian theory of markets with adverse selection and shows how refinements of equilibrium can be used to characterize uniquely the equilibrium outcome. Equilibrium exists under standard conditions. It is shown that, under certain conditions, a stable set exists and is contained in a connected set of equilibria. For generic models there exists a stable outcome, that is, all the equilibria in the stable set have the same outcome. These ideas are applied to markets with one-sided and two-sided uncertainty. Under standard monotonicity conditions, it is shown that the stable outcome is separating and implies a particular pattern of matches of buyers and sellers.