Why is too much leverage bad for the economy?

Felix Kubler and John Geanakoplos
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John Geanakoplos: Yale University

No 573, 2014 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper we show that competitive equilibrium prices and margin requirements naturally lead to too much leverage relative to the constrained optimum. We describe two mechanisms through which equilibrium forces lead agents to borrow too much and to hold too little collateral. To illustrate the first mechanism we present a very simple example without collateral and default where restricting borrowing leads to a Pareto-improvement over the competitive equilib- rium allocation because financial markets are incomplete. Limiting borrowing naturally leads to a change in spot-prices that makes all agents better off. We then introduce collateral, default, endogenous margin requirements and production and we illustrate the second mechanism by showing that the endogenous margin requirements are suboptimal because they result in too much default. Finally we show how the two effects interact - forcing agents to leverage less leads to a Pareto-improvement because it reduces default and because it reduces borrowing.

Date: 2014
New Economics Papers: this item is included in nep-dge and nep-rmg
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed014:573

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