Managing Financial Crises: Lean or Clean?

This paper discusses the lean vs. clean policy debate in managing financial crises based on dynamic general equilibrium models with an occasionally binding collateral constraint. We show that a full state-contingent subsidy for debtors can restore the first-best allocations by forestalling disorderly deleveraging in a crisis. While this result appears to favor the clean policy against a lean policy that achieves the second-best allocation, further assessment points to various risks associated with the clean policy from a practical viewpoint. First, the optimal clean policy is likely to call for an unrealistically large amount of fiscal resources. Second, if the clean policy is activated with an empirically realistic intervention, the less-than-optimal clean policy incentivizes debtors to take on undue risks, exposing the economy to higher crisis probabilities. Finally, the less-than-optimal clean policy may give rise to huge welfare losses due to the policy maker's misrecognition of the state of the economy.