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Solving the Present Crisis and Managing the Leverage Cycle

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Abstract

The present crisis is the bottom of a recurring problem that I call the leverage cycle, in which leverage gradually rises too high then suddenly falls much too low. The government must manage the leverage cycle in normal times by monitoring and regulating leverage to keep it from getting too high. In the crisis stage the government must stem the scary bad news that brought on the crisis, which often will entail coordinated write downs of principal; it must restore sane leverage by going around the banks and lending at lower collateral rates (not lower interest rates), and when necessary it must inject optimistic capital into firms and markets than cannot be allowed to fail. Economists and the Fed have for too long focused on interest rates and ignored collateral.

Suggested Citation

  • John Geanakoplos, 2010. "Solving the Present Crisis and Managing the Leverage Cycle," Cowles Foundation Discussion Papers 1751, Cowles Foundation for Research in Economics, Yale University.
  • Handle: RePEc:cwl:cwldpp:1751
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    References listed on IDEAS

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    1. Markus K. Brunnermeier & Lasse Heje Pedersen, 2009. "Market Liquidity and Funding Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 22(6), pages 2201-2238, June.
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    4. Gromb, Denis & Vayanos, Dimitri, 2002. "Equilibrium and welfare in markets with financially constrained arbitrageurs," Journal of Financial Economics, Elsevier, vol. 66(2-3), pages 361-407.
    5. Emmanuel Farhi & Jean Tirole, 2012. "Collective Moral Hazard, Maturity Mismatch, and Systemic Bailouts," American Economic Review, American Economic Association, vol. 102(1), pages 60-93, February.
    6. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
    7. John Geanakoplos & Felix Kubler, 2004. "Leverage, Incomplete Markets and Crises," 2004 Meeting Papers 557, Society for Economic Dynamics.
    8. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2001. "International and domestic collateral constraints in a model of emerging market crises," Journal of Monetary Economics, Elsevier, vol. 48(3), pages 513-548, December.
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    10. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    11. Adrian, Tobias & Shin, Hyun Song, 2010. "Liquidity and leverage," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 418-437, July.
    12. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
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    More about this item

    Keywords

    Leverage; Collateral; Margins; Leverage cycle; Externality; Principal;

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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