The Leverage Cycle

From The Physics of Finance, Dec. 8, 2012:

My latest Bloomberg column will appear sometime Sunday night, I expect. I wanted to give readers a few links here to various key papers of John Geanakoplos on the leverage cycle, as well as a little further discussion of a few points.

First, this is the most detailed paper Geanakoplos has published (as far as I know) describing the leverage cycle -- the natural feedback process that repeatedly drives economies through cycles in which leverage rises, driving increasing asset prices, and then falls as investors become uncertain, more cautious, and demand more collateral, Prices then crash down accordingly. His argument is that leverage (determined by collateral rates) is a key macroeconomic variable completely independent from interest rates, and often just as important to the economy at large. In particular, increasing (decreasing) leverage is one key direct cause of increasing (or decreasing) prices. As evidence, look at the figure below for housing prices from 2000 through 2009. It shows how the average down payment required for sub-prime mortgages went up and then down, in both cases just in advance of housing prices. (Okay, this isn't proof of a causal link, I suppose, but it's enough to convince me.)

But before reading the "serious" paper I recommend first reading the text of this talk that Geanakoplos gave two years ago in Italy. It's much less formal and makes all the main points in a clear way.

From a practical point of view, I think two things stand out to me in his arguments:

First, given the clear importance of leverage in driving economic outcomes, it is quite remarkable that the Federal Reserve Bank has not in the past made any systematic effort to collect the kind of data it would need to monitor average collateral rates in the economy. Between 2000 and 2005, for example, no one at the Fed was going to banks and collecting information on how much collateral they were demanding when lending. This was just not considered a crucial macroeconomic variable. Judging from the tone in his talk, Geanakoplos finds this pretty amazing too. He mentions that the Fed contacted him in 2008 or so to get hold of data of this kind that he had collected. It seems that the Fed has now accepted the systemic importance of leverage and is seriously considering including leverage as a key variable in future macroeconomic monitoring. Whether banks and hedge funds will be required to report leverage levels, I don't know, but this idea is at least on the table. Good thing, I think....MORE