LEVERAGE, DEFAULT, AND FORGIVENESS: LESSONS FROM THE AMERICAN AND EUROPEAN CRISES
Yale University and Santa Fe Institute
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
Department of Economics
New Haven, CT 06520-8281
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