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.
John Geanakoplos is James Tobin Professor of economics at Yale University, an External Professor at the Santa Fe Institute, and a partner at Ellington Capital Management, a hedge fund that invests in mortgage backed securities.Lasse Heje Pedersen
Lasse H. Pedersen is at New York University, Copenhagen Business School, AQR Capital Management, CEPR, NBER, director of the American Finance Association, and an academic advisor for FTSE and NASDAQ OMX.