Leveraging and De-leveraging

Why should we believe that the big changes in leverage cause nasty recessions rather than are symptoms of them? I assume one could write down a model where either could happen.

In textbook models deleveraging wouldn't cause a recession but the process of the economy going into a major recession would look like deleveraging.

For example in IS-LM a sharp contraction in the IS curve would mean that desired savings greatly exceeded desired investment at the current interest rate.

If lots of people try to save but not lots of people are borrowing for investment then debt levels will fall rapidly.

In a New Keynesian framework with financial frictions the a dramatic increase in financial friction will reduce total credit intermediation which will manifest itself as a decline in debt levels.

Oneeyedman - your assumption is correct and the operative word is "belief". But deleveraging is deflationary, and regardless of where it occurs in the chronology of a nasty recession it produces a real effect. The lesson that might be taken is not that A causes B, but rather that a highly-leveraged economy is more vulnerable to type of severe downturn we've had.

Karl Smith - I'm tempted to paraphrase Dickens... "The textbook is a ass". If we define friction as wasted energy, then perhaps our understanding of economic phenomena would be lubricated by a few book burnings.

Suppose I take $100,000 out of my Roth IRA - which is largely invested in mortgages - and pay off my mortgage. I am de-leveraging. The economy is de-leveraging but nothing happens other than a small decline in the demand for financial intermediation services. The word de-leveraging doesn't explain anything because every debt is somebody's asset and zeroing out balance sheet entries is a non-event.

Now suppose I go underwater on my mortgage. My net worth has fallen. So I cut consumption to rebuild my net worth. My neighbor is doing the same thing. We are consuming less but for this reason investment opportunities disappear at the same time we save more. To a point this is a self-reinforcing process. Eventually, the economy finds ways to employ higher desired savings. But note, the fact that I have a mortgage is irrelevant to the story.

To say that recessions can be caused by the recognition of losses from malinvestment on a colossal scale makes sense. De-leveraging explains nothing.

Whereas if we view debt as the allocation of future resources to present goals, and a leveraged society as one committed to a specific outcome, the problem introduced by changes in our expectations and our circumstances becomes clear.

If we then consider that leverage is the result of confidence in human institutions and policies intended to protect us from change, we get to the philosophical heart of the issue. Do we adapt to the world, or does it adapt to us? Is society a shield, or a sword?

Costard,

I'm curious as to why you wrote your second paragraph. If it was meant to persuade, then you need to brush up on your persuasion skills. Try using logic for starters.

On the other hand if your goal was to vent, then I hope it felt good anyway. It caused some negative externalities to begin with. Also, surely you are smart enough that you can think of a way to vent in a manner that produces positive externalities (i.e. educates readers as opposed to engaging in mindless trolling).

Damn, I was referring to Costard's first post with my reply.

Here's my theory on recessions/depressions...which you certainly won't find in textbooks either...Perspectives Matter - Economics in One Lesson.

Arnold et al,

I believe that the micro-impact of leverage on financial markets is well "believed" and possibly understood by market participants. And when a market is relatively self countained, the effects of leverage on asset pricing and volatility are obvious. Extending this to all asset markets is logical and methodological possible. Extending its impact to the general economy would also seem logical, as its impact would work itself through the various channels in which financial and real asset values can affect macro variables. For what it is worth, I recommend having a look at the work done by Professor John Geanakoplos whose insights on this issue are well keeping in mind. I dug up a paper he wrote

http://cowles.econ.yale.edu/P/cd/d17a/d1715-r.pdf

some of which he discusses, actually, in the last two lectures of a Financial Markets course

http://oyc.yale.edu/economics/econ-251#sessions

Deleveraging results in deeper recessions because bankers refuse to loosen their grip on the economy. Remember when Greenspan was warning they would be out of traction if the government paid off its debt?