Arnold Kling  

Geanakoplos on Leverage Cycles

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David Warsh points to this lecture.


variation in leverage has a huge impact on the price of assets, contributing to economic bubbles and busts. This is because for many assets there is a class of buyer for whom the asset is more valuable than it is for the rest of the public (standard economic theory, in contrast, assumes that asset prices reflect some fundamental value). These buyers are willing to pay more, perhaps because they are more sophisticated and know better how to hedge their exposure to the assets, or they are more risk tolerant, or they simply like the assets more. If they can get their hands on more money through more highly leveraged borrowing (that is, getting a loan with less collateral), they will spend it on the assets and drive those prices up. If they lose wealth, or lose the ability to borrow, they will buy less, so the asset will fall into more pessimistic hands and be valued less.

This looks interesting. More comments follow.

As he points out, the focus of macro has traditionally been on the interest rate, not on the leverage ratio. It is not easy to get the leverage ratio to matter in a model where everyone has similar preferences and identical views of the probability distribution of outcomes.

In my own view of the issue, financial intermediaries play a big role in managing and disguising leverage. I think of the nonfinancial public as wanting to hold short-term, riskless assets (checking accounts) and issue long-term, risky liabilities (in order to invest in houses, fruit trees, or what have you). The financial sector meets the public demand by holding the risky liabilities and issuing the low-risk assets. For me, the cycle comes from everyone becoming increasingly sanguine about what the intermediaries are doing, until there is bad news and people lose confidence in the intermediaries.

I think that our views lead to similarities in the cycle. But my view may have slightly different policy implications. In particular, in his model, a crash can be reversed by having the government step in and fix loans. In my model, the loss of confidence in the intermediaries is not really fixable.

Geanakoplos writes,


...Bad news in my view must be of a special kind to cause an adverse move in the leverage cycle. The special bad news must not only lower expectations (as by definition all bad news does), but it must create more uncertainty, and more disagreement.

In my view, bad news serves to unmask the intermediaries as having manufactured too many short-term liabilities out of long-term risky assets. The financial sector needs to contract, and the economy's asset and liability mix needs to be re-arranged. The economy has invested in too many risky projects (houses, fruit trees) and needs to cut back. The public does not really want to hold such a risky portfolio, and the intermediaries can no longer disguise the risks from the public.

I prefer the intuition in my view to that in Geanakoplos's model. However, I have to give him credit for making very explicit all of the assumptions in his model. He lays out all of the weird assumptions about the structure of information and lack of ability to create securities that pay off according to how information is revealed (the latter assumption seems quite contrived).

For my part,I have not spelled out what it is the enables an "intermediary" to operate. In my mind, a bank has lower cost than an individual for evaluating and monitoring risky projects. Thus an individual thinks as follows: I am willing to invest in risky projects through a bank rather than directly on my own. But I do not want to invest on the same terms as the bank. I want the bank to take most of the risk, in exchange for which I will take a lower return. I do not know exactly how the bank invests my money. I just figure that it knows what it is doing. Over time, the bank may get really confident in what it is doing, and I may share that confidence. The bank keeps expanding.

At some point, something happens to cause a loss of confidence in financial intermediaries. People start to pull out and attempt to switch to low-risk assets. The bank then has to contract. If that takes place in the economy as a whole, you get a de-leveraging cycle.

In some sense, the bank managers may be only slightly less ignorant of the bank's risks than their individual depositors. The bank managers can self-deceive. That self-deception would probably play an important part if I were to write down a model.

In conclusion, I think that leverage cycles are an important point of focus. I am not persuaded that Geanakoplos has put together the best depiction of the leverage cycle.


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COMMENTS (7 to date)
fundamentalist writes:

Hayek’s “Monetary Theory and the Trade Cycle” is much better on this subject. The emphasis on credit expansion is exactly the right place to look for one’s keys. This was one of the main conclusions of Kindleberger’s “Manias, Panics, and Crashes: A History of Financial Crises”. As Hayek points out, the credit expansion take take place on its own as individual banks respond to the desire for businesses to borrow, or it can be instigated by the Feds with a loose money policy, but the effect are the same. However, banks and businesses become less risk averse when the Fed interest rate is low and more risk averse when businesses start defaulting on loans.

SM writes:

geanakoplos is a MD and head of research at the biggest mortgage hedge fund in the world, and has been for more than a decade, which provides him with a better understanding of how actual markets work than the vast majority of financial economists. though his fund lost huge amounts of money in the last 2 years and they've suspended redemptions so it doesn't seem that his understanding of these concepts was worth too much in the end.

Jody writes:

standard economic theory, in contrast, assumes that asset prices reflect some fundamental value

Did I learn the wrong economics? I thought demand curves sloped down, i.e., there's no fundamental "value" to anything, only a distribution of prices for which people are willing to pay and each individual's willingness to pay anything was all contextual.

As an example of context, how much would you pay for a 5.25 floppy today vs 25 years ago? What then is the "fundamental value" of that floppy?

Monte McKenzie writes:

Thank you for the Econospeak! I've been watching for some article by a real economist ( I'm an old arm chair type at 78 yrs.)

Leverage control has concerned me for the last 20 years. There has been erosion of regulations,or even the impossibility of controls when dealing with international investors. Who are not subject to or controlled by any leverage regulation at all!!!No brokerage firm will refuse orders as long as the alusion is in place that those placing the order have the funds to cover. Even when they are theoretically regulated, there are many ways of evading regulation that Almost no practical way exists to enforce regulation!!!We all know that between the Fed and FDIC and States, regulations were in place to stop virtually all of the "bubbles" of the past 15 years. None have worked because the Regulators refused to employ them. And even used their powers to make them worse.
I have never read any proposals that would stop leveraging. Or limit it to a level that assure a safe market. Investors have found ways to escalate leverage well beyond any reguard for a trouble free market liquidity!!!

So why don't you smart guys propose some systems that would thwart the human greed factor and create a level playing field for investors world wide??? Now all we have ( in my view) is a crap shoot Not real investment oportunities!!!

scott clark writes:

Jody,
Good point. But I assume he was referring to financial assets in your quotation above. Financial assets (standard economists would say) should have some fundemental value related to the NPV of the expected future cash flows. This include real estate, its value should be fairly tightly related to the stream of rents that could be collected from the property, but this will get mixed up with government policy, zoning, taxes, interest deductibility, and all that jazz.

fundamentalist writes:

Scott, That's right. The "fundamental value" should be the NPV, which changes with the forecasts of earnings and the discount rate. I'm not so certain that risk tolerance changes radically as does the NPV due to changes in forecasts and discount rates.

Joe Calhoun writes:

Is it just me or is this just blindingly obvious? The easy availability of credit can cause asset prices to rise beyond where they would otherwise? Prices can become unhinged from fundamental value (a bubble) with enough leverage? Well, yeah, that has happened....repeatedly throughout history.

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