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LEVERAGE, DEFAULT, AND FORGIVENESS: LESSONS FROM THE AMERICAN AND EUROPEAN CRISES

 

 

 

 John Geanakoplos

Yale University and Santa Fe Institute

 

 

 

ABSTRACT

This paper argues that in ebullient times equilibrium leverage and asset prices are too high; in bad times, equilibrium leverage and asset prices are too low. This is the leverage cycle. Looking at the recent American and European crises, the paper draws lessons for central banks about how to avoid another leverage cycle crisis. It argues that central banks should collect information regarding leverage to map out the entire credit surface. Instead of just the riskless interest rates, they should target the whole credit surface and use leverage an instrument. After a crisis, they should partially forgive some of the debt.

 

 

Keywords: Leverage Cycle, American and European Crises, Credit surface, Debt forgiveness

JEL Classification: G01, G18, E44

 

  

Correspondence:

John Geanakoplos

Yale University

Department of Economics

Box 208281

New Haven, CT 06520-8281

e-mail address: john.geanakoplos@yale.edu



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