Most economists, politicians and businesspeople have accepted the business cycle as unavoidable and see the Fed Funds Rate, the key interest rate controlled by the Federal Reserve Bank, as the main means of smoothing out that cycle. However, with the Fed Funds Rate at essentially zero, the Fed has run out of conventional ammunition for its battle against the credit crisis.
John Geanakoplos, Yale’s James Tobin Professor of Economics, though, has proposed an unconventional way in which the Federal Reserve can control the boom-and-bust cycle by controlling leverage, or how much people can borrow against collateral.
Geanakoplos said he believes the leverage cycle was a major contributor to the current economic crisis. When the economy is booming, firms routinely borrow as much as 95 percent of the money they use to purchase assets. In so doing, they underestimate the risk of the assets they buy and, eventually, losses pile up quickly when prices drop only slightly.
As prices drop, Geanakoplos argues, fear makes lenders unwilling to lend, leaving many borrowers unable to use leverage at all. Without credit, new loans — necessary to hire new workers, buy new equipment and purchase consumer goods — become a rare luxury.
Because fluctuations in leverage can be so dangerous, Geanakoplos proposes that the Fed control its availability to borrowers. Under his plan — which he has presented to Chairman Ben Bernanke himself — the Fed would limit leverage when the economy is booming in order to prevent investors from taking on too much risk, and it would make leverage more available when banks are too afraid to provide it.
This would be a new mandate for the Fed. But Geanakoplos argues that the Fed can, with the right personnel, can provide the “adult supervision” investors may not want but so desperately need.
But can the Fed successfully mimic a private financial institution by assessing the risk of various securities and preventing all investors from over-leveraging?
Though I agree with Geanakoplos that the Fed should monitor leverage more closely when it is setting interest rates (since manipulating interest rates would have an indirect effect on leverage), I am not certain that his plan would be feasible.
Mainly, under Geanakoplos’ plan, the Fed would have to decide when leverage is “too high” — a difficult task. Now, the Fed does make a similarly subjective decision when it sets interest rates, but leverage is much harder to monitor. There are only two interest rates the Fed controls, but borrowers can leverage using just about anything as collateral (from cash or government bonds to real estate or commodities). In order to manage leverage, the Fed would have to observe the leverage available to holders of every conceivable type of asset and determine when investors are taking on too much risk.
The Fed is a government institution, not an investment bank. It employs economists, not securities analysts or hedge fund managers. In order to take on the gargantuan task of performing risk assessment on every market, it would have to hire Wall Street analysts (which would be easy to do now, but much harder to do when opportunities for these workers are available elsewhere).
If the Fed does decide to monitor the leverage available on all of these assets, it would have to know when an asset is risky when most financial institutions disagree. Unfortunately, it would employ people who have worked for the institutions that were unable to foresee the risk of over-leveraging, and then it would give them the task of trying to do exactly that. To be fair though, at the Fed, these employees’ incentives would be very different, and they would not be pressured, this time, to ignore risk.
As for increasing leverage when credit is unavailable, I believe Geanakoplos is exactly right. People are willing to buy the toxic assets that banks are holding, but no one will give them the leverage to do so. Though the Fed has already begun to do this through its Term Asset-Backed Securities Loan Facility, it should make providing leverage to borrowers more of a priority in order to unfreeze credit markets and increase the value of the toxic assets banks are holding and stabilize home prices.
Essentially, we should focus on increasing leverage now. Geanakoplos’ plan — that the Federal Reserve should provide that leverage itself — would expedite economic recovery. The task of preventing over-leveraging, though, may prove too colossal.
Marcus Shak is a freshman in Pierson College.