11.04.09
Eve of ‘New Paradigm’ for Taming Boom-Bust Cycle
John Geanakoplos of Yale was asked by the Fed to present his views on the crisis at its peak in October 2008. His theories moved away from the efficient markets and rational expectations camps to a “leverage cycle” point of view. He shows how a group of certain types of investors that demand, say more “asset-backed” securities, encouraged banks to ‘stretch’ their available supply of collateral like mortgage loans. “Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels, ” writes the Wall Street Journal (Nov. 3, “Crisis Compels Economists…” by Mark Whitehouse). Under usual circumstances, the less leveraged buyer would not venture into these securities at higher prices; therefore this phenomenon violates the idea of efficient markets, that all available information is contained in prices of securities.
Basically, Geanakoplos says the banks created myriad debt securities to meet demand. Central bank models missed this leverage cycle because their models focus mainly on interest rates. If new thinking proves out, the way in which we have viewed the financial world will change. Whatever new ideas become accepted as the norm may be a welcome change: “Our policy seems geared toward rescuing banks and bankers.” per Geanakolpos. He hopes a paradigm shift will occur so that people are protected against the excesses of the financial markets. He suggests central banks should collect and publish data on the amount of leverage in the system. Sounds like a good start.
