Welcoming another cycle – Leverage Cycle

Most people know only of their bicycles and motorcycles. Not satisfied with the two, economists have developed their own sets of cycles – Business Cycle, Financial Cycle, Product Life Cycle etc.

John Geanakoplos of Yale University has come out with another cycle – Leverage Cycle. (Thanks to Dani Rodrik  for the pointer). The concept is very important and I am surprised that it took economists so much time to acknowledge the same. He has written three papers explaining the idea:

The Leverage Cycle (given at NBER conference) 
Leverage Cycles and the Anxious Economy
Liquidity, Default, and Crashes: Endogenous Contracts in General Equilibrium

His broad idea is that till now we assume in a loan market, demand and supply only determine the interest rate on loans. He adds apart from interest rate it also determines the leverage (or collateral) with the loan. In good times, lenders don’t require collateral leading to a higher leverage. In bad times, the lenders demand more collateral and asa result leverage declines (deleveraging). So, the demand supply equation does not determine one (interest rate) but two variables (interest rate and leverage).

Fed usually tries to think interest rates alone would solve the problem (increase it when times are good) and decrease it (when times are bad). However, it should also think about damping the leverage cycle which usually follows the opposite trend.

David Warsh has a neat profile of Geanakoplos’s work:

For at least a century, he noted, economists have been accustomed to thinking of the interest rate as the most important variable in the economy – lower it to speed things up, raise it to slow them down. Yet especially in times of crisis, collateral demands – alternatively, margin requirements, loan-to-value ratios, leverage rates or “gearing” – become much more important.

 

Everybody knows that when interest rates go down, prices rise.  Less widely recognized is that when margin requirements go down – say, the down payment on a house – prices rise too, often even more. Without some form of control, leverage becomes too high in boom times, and asset prices soar disproportionately. When they crash, leverage crashes with them, and then prices suddenly are too low.  This is the leverage cycle, Geanakoplos says, and the current crisis is the result of a particularly virulent specimen. Intervention can mitigate its worst effects.

 

He also says importance of collateral was known to even Shakespeare:

 

And the fundamental insight – that a single loan requires not one but two terms to be negotiated, and that one may become much more important than the other in certain situations was clear enough to Shakespeare four hundred years ago. Wrote Geanakoplos: “Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral –a pound of flesh but not a drop of blood.” Thus did the The Merchant of Venice end happily, not with a cramdown, but with very different terms if the loan were to be foreclosed.

 

Why did it take so long for the idea to catch on?

 

“After it was published finally published, as “Liquidity, Default, and Crashes” in the conference volume in 2003, I gave that Seattlepaper at every major university.  It was exactly about the liquidity cycle, but it didn’t really catch on,” Geanakoplos recalled last week. The time for it wasn’t ripe. The Asian financial crisis had been contained.  No lender lost a dollar when LTCM failed. The consequences of the dot.com crash had been confined mainly to the stock market. For the next seven years, business as usual resumed. “This time they are more interested.”

 

This  is so typical of economists. You hear this story common. All the best papers were rejected outright by journals/economists. Akerlof’s Lemons paper, Black Scholes Option Pricing Paper, Krugman’s international trade and increasing returns paper….all seem to have had the same story.

 

I am no one to say whether Leverage Cycle is in the same league. On reading this paper – The Leverage Cycle, I could see it has important insights. So far I have never read any paper which stitches the theory of collateral and interest rates so neatly. Dani Rodrik in his blog says:

 

So add John Geanakoplos to the (short) list of economists we should all have been listening to more intently (Bob Shiller, Nouriel Roubini, Raghu Rajan, ???).