NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Monitoring Leverage

John Geanakoplos, Lasse Heje Pedersen


This chapter is a preliminary draft unless otherwise noted. It may not have been subjected to the formal review process of the NBER. This page will be updated as the chapter is revised.

Chapter in forthcoming NBER book Risk Topography: Systemic Risk and Macro Modeling, Markus K. Brunnermeier and Arvind Krishnamurthy, editors
Conference held April 28, 2011
Forthcoming from University of Chicago Press

We argue that leverage is a central element of economic cycles and discuss how leverage can be properly monitored. While traditionally the interest rate has been regarded as the single key feature of a loan, we contend that the size of the loan, i.e., the leverage, is in fact a more important measure of systemic risk. Indeed, systemic crises tend to erupt when highly leveraged economic agents are forced to deleverage, sending the economy into recession. We emphasize the importance of measuring both the average leverage on old loans (which captures the economy’s vulnerability) and the leverage offered on new loans (which captures current credit conditions) since the economy enters a crisis when leverage on new loans is low and leverage on old loans is high. While leverage plays an important role in several economic models, the data on leverage is model-free and simply needs to be collected and monitored.

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