Geanakoplos on Leverage Cycles
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.
…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.