Friday, January 29, 2010

It's All About Leverage

Last week, both Rajiv Sethi and then Mark Thoma, who republished Sethi's post with an additional interview and links, had posts on John Geanakoples and his general equilibrium model of asset pricing.  In this model leverage along with collateral and default play a key roles.  This is a concept he has been developing since a paper first published in 1997.  The catalyst for these posts is a paper entitled "The Leverage Cycle" which is to be published early this year in the NBER Macroeconomics Annual, which means it will be available for purchase only to non-members.  However, he has published a version dated January 2010 as a discussion paper at the Cowles Foundation.  Of the series of papers preceding this, there is one on leverage cycles which contains a considerable amount of the mathematical logic involved in the model.

The attention arises, because this leverage model provides a theoretical model for understanding how we arrived at the current financial crisis, how we can recognize asset bubbles, and implies the use of leverage once an economy is in a financial crisis.  In good times, in the absence of intervention, asset prices and leverage are too high and, in bad times, asset prices and leverage are too low.  His conclusion that the Fed should actively "manage system wide leverage, curtailing leverage in normal or ebullient times, and propping up leverage in anxious times", to me, offers an opportunity to formulate a Leverage Rule, despite not being responsive to only inflation and output gap.

The Leverage Cycle model includes distribution of wealth across individuals (level of inequality), heterogeneous agents, , incomplete markets, asymmetric  information, and endogenous leverage cycles..  The looser the collateral requirements, the higher asset prices will be.  With leverage as endogenous rather than fixed, as in prior equilibrium models, then the extent of leverage should be determined jointly with the interest rate for loans in the market, which means one must recognize that loan contracts can differ along both dimensions of leverage and interest rates.  As Sethi surmises, this means "Conceptually, we must replace the notion of of contracts as ordered pairs of promises and collateral."

Bernanke has been very adamant that the Fed cannot recognize asset bubbles prior to bursting, although he has recently, although reluctantly, indicated that it would be appropriate if the Fed could recognize asset bubbles, while still equivocating that he does not see how it could be done practically.  The Leverage Cycle shows that in crisis leverage becomes too low.  In the current crisis we continue to see deleveraging in housing and credit default swaps.  I have been very adamant that the unregulated growth of derivatives privately trade rather than public traded on a transparent market multiplied the leverage in the economy, not just housing but also in any other area of credit.

When I read The Leverage Cycle and its use of endogenous leverage, Steve Keen and his modeling of endogenous money supply and how similar the two models are immediately leapt into my mind.  There are those who have claimed that Steve Keen predicted the current financial crisis.  Keen's recent post on why Bernanke should not be reappointed Fed chairman (which he was yesterday and I have been ambivalent on his reappointment for a variety of reasons too long for here) is a good example of Keen and Geanakoples have both used Irving Fisher, as he corrected himself post 1929 Crash.  Keen argues that Bernanker, despite being a scholar of the Great Depression does not understand the Great Depression, because Bernanke, by his published work and his public actions, has apparently never considered Fisher's argument that over-indebtedness and low inflation in the 1920's created a chain reaction which caused the Great Depression.  Fisher also delineated a dynamic process in which falling asset and commodity prices create pressure on nominal debtors, forcing distress sales, which in turn lead to further price declines and financial difficulties.  In other words, a financial crisis is a debt driven disequilibrium in which current equilibrium models of inflation and output gaps do not work and The Great Moderation, with its false belief in the end of economic volatility with greater economic predictability which encouraged increased debt levels and insufficient acknowledgment of risk, has been revealed as The Great Enabler.  Keen shows that an analysis of debt, aggregate demand, and nominal GDP could be used by the Fed to identify potential problems and the possibility that one or more asset bubbles exist.  Consequently, Bernanke's actions once the crisis erupted did reduce the immediate impact, but Keen is adamant that Bernanke and the Fed could have seen it coming if Bernanke and other economists had not ignored the debt-driven cause of The Great Depression.

To me, John Geanakoples and Steve Keen are working towards the same concept from divergent perspectives but common ground.  To me, it also brings into question how liquidity has been used and distributed during the crisis and its impact on the distribution of wealth and aggravation of income equality.  It also reinforces my long held belief that the fiscal stimulus was too little, too slow in spending, and not efficiently targeted towards correcting unemployment quickly.  By not utilizing fiscal policy to significantly improve unemployment by the end of Q2 2010, which I have maintained was necessary for almost year or more, the government and the Fed have insured this recession will linger for an intolerable period with preferential liquidity practices (bailouts) and the inefficient increase in national debt.

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