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trade adjustments, spurred in part by devaluation, were central to the resolution of the crisis; the bail-out, by temporarily leading to an exchange rate that was higher than it otherwise would have been, may in fact have impeded adjustment.
    8 In these models, there is no way that market participants can anticipate when the economy might shift from one equilibrium to another.
    9 See also the earlier work of Myers and Majluf (1984) and Greenwald, Stiglitz and Weiss (1984).
    10 Either because managers are forced to bear some risk, as part of optimal incentive contracts, or because of bankruptcy costs. See Greenwald and Stiglitz (1990).
    11 Moreover, the value of firm equity can change rapidly, and there may be many claimants.
    12 Similarly, Miller and Stiglitz (2010) use a model with collateral requirements to demonstrate how shocks can turn into crises in the presence of high leverage and overvalued assets.
    13 More recent research has emphasised that individuals discount information that is inconsistent with their priors, and overweight information that is consistent. If a bubble is forming, they tend to weigh more heavily the information that is consistent with their beliefs. There can be equilibrium frictions, where they ‘rationally’ believe that there is a bubble (see Hoff and Stiglitz, 2010).
    14 Traditional economic theory – and economic policy – has taken ambiguous positions about these destabilising adjustments. It has been standard fare to worry about ‘overshooting’. Excessive exchange rate adjustments, it is thought, impede the adjustment of the market economy to the new (or ‘correct’) equilibrium, and this provides justification for interventions to reduce the magnitude of the exchange rate adjustment. In some cases, there is evidence that such interventions actually impede the adjustment process. Indeed, one set of studies suggests that it was the normal foreign exchange adjustment mechanism which restored Mexico’s growth, and that attempts to dampen the foreign exchange correction (driven by concerns about impact on foreign creditors) slowed down adjustment. In particular, if there had been larger foreign exchange adjustments accompanied by debt restructuring, the economy arguably would have recovered more quickly (Lederman, Menendez, Perry and Stiglitz, 2001, 2003).
    15 Standard macro theories are of two minds about the role of wage and price rigidities. While the Hicksian IS-LM tradition focuses on wage and price rigidities, the Fisherian tradition revived by Greenwald and Stiglitz (1993a, 1993b, and the articles cited there) emphasises that with imperfectly indexed debt contracts wage flexibility may exacerbate economic downturns. In a model where both wages and prices are flexible, but imperfectly so, the economy can have sustained unemployment (see Solow and Stiglitz, 1968).
    16 Although many sources mention contagion, no consensus has emerged on the precise definition of contagion (see, for example, Gallegati, Greenwald, Richiardi and Stiglitz, 2008). In the broadest sense, contagion involves spill-overs of economic events from one country to other countries (or, in the context of lending, from one borrower to other borrowers). A narrower view, more specific to crisis episodes, defines contagion as an increase in correlations among two countries in bad times or, in the words of Dornbusch, Park and Claessens (2000, p. 178), ‘a significant increase in cross-market linkages after a shock to an individual country, as measured by the degree to which asset prices or financial flows move together across markets relative to this co-movement in tranquil time.’
    17 Bank decisions in anticipation of contagion can increase the level of systemic risk. For example, Acharya and Yorulmazer (2008) consider the lending decisions of banks affected by common as well as idiosyncratic shocks. If one bank fails, investors update their assessment of other banks. Investors are