The leverage cycle February 1, 2010 at 9:07 am
Rajiv Sethi writes:
In a series of papers starting with Promises Promises in 1997, John Geanakoplos has been developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role… The latest paper in the sequence is The Leverage Cycle, to be published later this year in the NBER Macroeconomics Annual. Among the many insights contained there is the following: the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs.
Sethi is right: this is important work. What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ’29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?