Leverage, Default, and Forgiveness: Lessons from the American and European Crises

This paper argues that macroeconomic stability depends less on riskless interest rates than on leverage and other measures of credit conditions, like average FICO scores of borrowers. It suggests that the leverage cycle played a central role in the recent American and European financial crisis. In the leverage cycle, asset prices and leverage rise when volatility is low and then fall as volatility rises. Sometimes asset prices fall so far below debt levels that it would be better for everybody if debt were partially forgiven. The paper recommends that central banks regularly monitor and forecast the whole credit surface, and in extreme cases intervene to regulate risky interest rates and impose partial debt forgiveness.