Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/30702
Authors: 
Stein, Jerome L.
Year of Publication: 
2010
Series/Report no.: 
CESifo working paper 2924
Abstract: 
A healthy financial system encourages the efficient allocation of capital and risk. The collapse of the house price bubble led to the financial crisis that started in 2007. There is a large empirical literature concerning the relation between asset price bubbles and financial crises. I evaluate the key studies with the respect to the following questions. To what extent do the empirical relations in the existing literature help to identify asset price bubbles ex-ante or ex-post? Do the empirical studies have theoretical foundations? On the basis of that critique, I explain why the application of stochastic optimal control (SOC)/dynamic risk management is a much more effective approach to determine the optimal degree of leverage, the optimum and excessive risk and the probability of a debt crisis. The theoretically founded early warning signals of a crisis are shown to be superior, in general, to those empirical relations in the literature. Moreover the SOC analysis provides a theoretical explanation of the extent that the empirical measures in the literature can be useful.
Subjects: 
stochastic optimal control
mortgage and financial crises
Ito equation
optimal dynamic risk management
warning signals of crisis
optimal leverage and debt ratios
Congressional Oversight Panel
Case-Shiller index
JEL: 
C61
D81
D91
D92
G10
G11
G12
G14
Document Type: 
Working Paper

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