Did Not Understanding The Leverage Cycle Kill The Economy?
David Warsh’s latest economics column delves into the renewed interest being given to economist John Geanakoplos’ paper explaining how the real issue that brought down the economy was a misunderstanding of “the leverage cycle.” Basically, the argument is that everyone (mainly, the Fed) gets so focused on the interest rates, that they stop focusing on the leverage/collateral involved. It’s sort of the central banker equivalent of when the mortgage broker tries to get you to ignore all the real terms in your mortgage and just gets you to focus on how much you’ll be paying each month. The argument, then, is that the government could have done much more to prevent the crisis if it had simply paid more attention to the leverage situation, which had obviously grown totally out-of-hand. Basically, the argument says that in a competitive market for credit, leverage will always rise, as some parties take bigger and bigger risks, forcing others to do the same. But then everyone’s way overleverag
