Traditionally, booms and busts have been attributed to investors' excessive or insufficient demand, irrational exuberance and panics, or fraud. The leverage cycle begins with the observation that much of demand is facilitated by borrowing, and that crashes often occur simultaneously with the withdrawal of lending.
Lenders are worried about default, and therefore attach credit terms like collateral or minimum credit ratings to their contracts. The credit surface, depicting interest rates as a function of the credit terms, emerges in leverage cycle equilibrium. Investors and lenders (and regulators) choose where on the credit surface they trade. The leverage cycle is about booms when credit terms, especially collateral, are chosen to be loose, and busts when they suddenly become tight, in contrast to the traditional fixation on the (riskless) interest rate.
Leverage cycle crashes are triggered at the top of the cycle by scary bad news, which has three effects. The bad news reduces every agent's valuation of the asset. The increased uncertainty steepens the credit surface, causing credit terms to tighten on new loans, explaining the withdrawal of credit. The high valuation leveraged investors holding the asset lose wealth when the price falls; if their debts are due, they lose liquid wealth and face margin calls, and may be forced to sell their collateral. Each effect feeds back and exacerbates the others, and increases uncertainty.
The credit surface is steeper for long loans than short loans because uncertainty is higher. Investors respond by borrowing short, voluntarily exposing themselves to margin calls.
When uncertainty rises, the credit surface steepens more for low credit rating agents than for highly rated agents, leading to more inequality. The leverage cycle also applies to banks, leading to a theory of insolvency runs rather than panic runs. The leverage cycle policy implication for banks is that there should be transparency, which will induce depositors or regulators to hold down bank leverage before insolvency is reached. This is contrary to the view that opaqueness is a virtue of banks because it lessens panic.
The steady application of Quantitative Easing (QE) has been followed by big and non-monotonic eﬀects on international asset prices and international capital flows. These are diﬀicult to explain in conventional models, but arise naturally in a model with collateral. This paper develops a general-equilibrium framework to explore QE’s international transmission involving an advanced economy (AE) and an emerging market economy (EM) whose assets have less collateral capacity. Capital flows arise as a result of international sharing of scarce collateral. The crucial insight is that private AE agents adjust their portfolios in diﬀerent ways in response to QE, conditional on whether they are (i) fully leveraged, (ii) partially leveraged or (iii) unleveraged. These portfolio shifts of international assets can diminish or even reverse the eﬀectiveness of ever-larger QE interventions on asset prices. The model provides a simultaneous interpretation of several important stylized facts associated with QE.
We prove that in competitive market economies with no insurance for idiosyncratic risks, agents will always overinvest in illiquid long term assets and underinvest in short term liquid assets. We take as our setting the seminal model of Diamond and Dybvig (1983), who ﬁrst posed the question in a tractable model. We reach such a simple conclusion under mild conditions because we stick to the basic competitive market framework, avoiding the banks and intermediaries that Diamond and Dybvig and others introduced.
We oﬀer new suﬀicient conditions ensuring demand is downward sloping local to equilibrium. It follows that equilibrium is unique and stable in the sense that rising supply implies falling prices. In our setting, there are two goods, which we interpret as consumption in diﬀerent time periods, and many impatience types. Agents have the same Bernoulli utility function, but the types diﬀer arbitrarily in time preference. Our main result is that if endowments are identical and utility displays nonincreasing absolute risk aversion, then market demand is strictly downward sloping local to equilibrium. We discuss implications for the Diamond-Dybvig literature.
Status is greatly valued in the real world, yet it has not received much attention from economic theorists. We examine how the owner of a ﬁrm can best combine money and status to get her employees to work hard for the least total cost. We ﬁnd that she should motivate workers of low skill mostly by status and high skill mostly by money. Moreover, she should do so by using a small number of titles and wage levels. This often results in star wages to the elite performers and, more generally, in wage jumps for small increases in productivity. By analogy, the governance of a society should pay special attention to the status concerns of ordinary citizens, which may often be accomplished by reinforcing suitable social norms.