Did Not Understanding The Leverage Cycle Kill The Economy?

from the something-worth-exploring dept

David Warsh's latest economics column delves into the renewed interest being given to economist John Geanakoplos' paper explaining how the real issue that brought down the economy was a misunderstanding of "the leverage cycle." Basically, the argument is that everyone (mainly, the Fed) gets so focused on the interest rates, that they stop focusing on the leverage/collateral involved. It's sort of the central banker equivalent of when the mortgage broker tries to get you to ignore all the real terms in your mortgage and just gets you to focus on how much you'll be paying each month. The argument, then, is that the government could have done much more to prevent the crisis if it had simply paid more attention to the leverage situation, which had obviously grown totally out-of-hand. Basically, the argument says that in a competitive market for credit, leverage will always rise, as some parties take bigger and bigger risks, forcing others to do the same. But then everyone's way overleveraged, and when the music stops, basically everyone's left without a seat. It's an interesting theory -- one that sounds good, though on a first read I'm not entirely convinced. While the issue of how much leverage was out there is obviously a part of the problem, I'm not entirely sure that the government would realistically be able to totally control the issue. While it could put in place certain regulations, it seems like there would always be loopholes that allowed leverage to occur elsewhere. Either way, I'm going to do some more reading on the subject, but wanted to pass it along here to see what others thought of it in the meantime.

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  1. identicon
    Freedom, 15 Apr 2009 @ 11:27am

    Ironic...

    It seems like we had all the government regulation needed but 'they' wouldn't pull the trigger. If the Fed Reserve would have raised the interest rates, it would have cut the legs out of the housing market before it got too bad, unfortunately, no one was willing to take the short term hit/pain and instead they let the bubble grow until it burst.

    One has to wonder if/when interest rates increase which has to happen at some point what this will do to an already poor housing market. If interest rates go from 5 to 10%, the average consumer will only be able to afford ~half as much home. While the price of the homes may hold or even rise due to inflation, I worry that the real value will decline rapidly when the interest rates go back to more historic levels and the # of real buyers decreases even further causing a 'reverse bubble'.

    If you take the demand part out of the equation, my house that I bought in 1993 is still 10 to 15% over priced (inflation dollar adjusted) if you assume a house just holds it core value. Add in coming increases in mortgage interest rates and I don't think we are anywhere near the bottom yet.

    Freedom

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