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Understanding Financial Crises: The Contribution of Experimental Economics Frank Heinemann Technische Universit?t Berlin Summer School on Experimental Macroeconomics, Barcelona 2011 Structure Phases of Financial Crises Bubbles and Crashes: rational behavior? Herding: limited levels of reasoning? Bank Runs: measures of prevention Refinancing Debt: a coordination game with strategic complementarities Predicting Behavior and Comparative Statics Managing Information Flow The Power of Sunspots Conclusion 1. Phases of Financial Crises Minsky (1975) 1. Trigger: (exogenous event), e.g. new technology, financial market  innovation 2. Boom: new opportunities for investing let profits rise. 3. Credit expansion: banks are transforming short-term deposits  into long-term credits. 4. Destabilising speculation: price bubbles, herding. = overinvestment 5. Crash: profits do not live up to previous expecations,  banks write off part of the outstanding debt. when does a bubble collapse? Phases of Financial Crises 5. Crash: profits do not live up to previous expecations,  banks write off part of the otstanding debts. 6. Reversal of capital flow: depositors try to withdraw. 7. Panic: panic sales cause rapid decline in asset prices.  The bubble bursts. 8. Liquidity squeeze: banks compete for scarce liquidity. Banks in need of refinancing, eventual illiquidity. 9. Liquidity spirals: banks sell long-term assets. = asset prices may fall below fundamental value. = More banks go bust. 2. Bubbles and Crashes Under which conditions may we expect a bubble to arise? Smith, Suchaneck, and Williams (Ecmta 1988): finite economy, subjects repeatedly trade an asset with an exogenously given fundamental value. Unique equilibrium: no trade, price = fundamental value. Experiment reliably generates bubbles and crashes. Dufwenberg et al. (AER 2005): If at least 1/3 of subjects are experienced (participated in the experiment before)