Economics Commons^™

Leverage Cycle Theory Of Economic Crises And Booms, John Geanakoplos

Cowles Foundation Discussion Papers

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 …