A front page article in today’s Wall Street Journal argues that “Crisis Compels Economists to Reach for New Paradigm.” It features a discussion of Yale economist John Geanakoplos’s “previously obscure” theories that focus on the role of collateral and leverage in financial bubbles and cycles.
Professor Geanakopolis says that he was inspired to examine the role of collateral while re-reading Shakespeare’s Merchant of Venice, where pound-of-flesh collateral plays a such a prominent role. From the article …
The play’s focus is collateral, with the money lender Shylock demanding a particularly onerous form of recompense if his loan wasn’t repaid: a pound of flesh. Mr. Geanakoplos, too, finds danger lurking in the assets that back loans. For him, the risk is that investors who can borrow too freely against those assets drive their prices far too high, setting up a bust that reverberates through the economy.
Collateral is of course the fulcrum on which leverage is based, with borrowed funds being the arm that transmits the force. You would think that financial economists would have taken the leverage effect into account — it certainly plays a big part in my analysis of “financial globaloney” in Globaloney 2.0 — but the WSJ reports that
Mr. Geanakoplos is among a small band of academics offering new thinking about those cycles. A varied group ranging from finance specialists to abstract theorists, they are moving to economic center stage after years on the margins. The goal: Fix the models that encapsulate economists’ understanding of the world and serve as policy-making tools at the world’s biggest central banks. It is a task that could require a thorough overhaul of the way those models work.
“We could be looking at a paradigm shift,” says Frederic Mishkin, a former Federal Reserve governor now at Columbia University.
Paradigm shift? About time.