Leverage cycles, liquidity and anxiousness

The American Economic Review, Fostel and Geanakoplos article, Leverage Cycles and the Anxious Economy provides a good background piece on how markets got into the current financial mess. We are in a classic leverage cycle. This work extends the ideas of Minsky by adding more structure around the idea that leverage follows a natural cycle of increasing extension and then decline. The credit or leverage extension is a result of the increases in prices for assets which are bought on borrowed money. Higher prices leads to more lending with the increased value of collateral. Leverage will increase with price increases. When there is a shock to the price system, there will loans will be called and leverage will have to decline. Like many markets there will be overshooting on the way up and down.

The interesting twists by the authors are to show that leverage cycles are more likely for emerging markets or those that have liquidity constraints based on the lack of general public interest. The marginal buyers have limited wealth and borrow money and are more sensitive to any price shock. They will be more anxious to any price reversal since their purchase was based on borrowed money. These markets, where there is more use of leverage, will be more subject to contagion.

More importantly, levered markets are more likely to have a liquidity wedge between the price willing to be paid. Liquidity wedges based on the differences of opinion between buyers and sellers will lead to more dramatic price changes when there is a change in information. This type of behavior was associated with ABS, CBO's and credit derivatives. There will then be spillover effects to the general economy until the level of anxiousness subsides.