Leverage Cycles and the Anxious Economy (American Economic Review, Vol. 98, No. 4, September 2008)

by Ana Fostel and John Geanakoplos

Just as there’s a business cycle with booms and recessions, so there is a leverage cycle. And the two are intimately connected. This paper gives an explanation for how a relatively small piece of bad news can give rise to a big deterioration – in liquidity, lending, and production. The government then has to step in, but, according to this paper, it can also act beforehand to limit crises by constraining leverage.