In a January 2009 lecture on the financial crisis, Federal Reserve Chairman Bernanke advocated a new Fed policy of credit easing, defined as a combination of lending to financial institutions, providing liquidity directly to key credit markets, and buying of long term securities. We show that Bernanke's analysis and recommendations can be naturally considered in a model of "unstable banking," which relies on two mechanisms: 1) fire sales reduce asset prices below fundamental values, and 2) financial institutions prefer speculation to new lending when markets are dislocated. We analyze credit easing and compare it to alternative government interventions during the crisis.

We model a financial market in which investor beliefs are shaped by representativeness. Investors overreact to a series of good news, because such a series is representative of a good state. A few bad news do not change investor minds because the good state is still representative, but enough bad news leads to a radical change in beliefs and a financial crisis. The model generates debt over-issuance, “this time is different” beliefs, neglect of tail risks, under- and over-reaction to information, boom-bust cycles, and excess volatility of prices in a unified psychological model of expectations.