Discover the Perils of Debt in Leveraged by Moritz Schularick

The New Economics of Debt and Financial Fragility. In “Leveraged: The New Economics of Debt and Financial Fragility,” renowned economist Moritz Schularick brilliantly exposes the alarming realities of our debt-driven global economy. This groundbreaking book offers an eye-opening exploration of the precarious relationship between debt and financial stability, shedding light on the potential dangers that lurk beneath the surface of modern finance.

Discover the hidden truths behind our debt-ridden world and arm yourself with the knowledge to navigate the complex landscape of contemporary economics. Keep reading to uncover the key insights and thought-provoking arguments presented in this must-read book.

Genres

Economics, Finance, Macroeconomics, Debt, Financial Crisis, Economic Policy, Monetary Policy, Banking, Investment, Economic History

In “Leveraged: The New Economics of Debt and Financial Fragility,” Moritz Schularick delves into the intricate world of debt and its profound impact on financial stability. The book explores how the increasing reliance on debt has reshaped the global economic landscape, creating a precarious environment prone to crises and instability. Schularick meticulously examines the historical patterns of debt accumulation and its consequences, highlighting the recurring cycles of boom and bust that have plagued economies throughout history.

The author argues that the current economic paradigm, characterized by high levels of debt and leverage, has amplified the risk of financial fragility. He points out that the traditional safeguards and regulatory measures have often proven inadequate in mitigating the systemic risks associated with excessive debt. Schularick emphasizes the need for a fundamental reassessment of our understanding of debt and its role in the economy, calling for a more cautious and prudent approach to debt management.

Throughout the book, Schularick presents a compelling case for rethinking the prevailing economic models and policies that have encouraged the unbridled accumulation of debt. He highlights the importance of recognizing the inherent instability of highly leveraged systems and the potential for contagion during times of crisis. The author also explores the social and political ramifications of debt, discussing how the unequal distribution of debt burdens can exacerbate economic inequality and social tensions.

Review

Moritz Schularick’s “Leveraged: The New Economics of Debt and Financial Fragility” is a groundbreaking work that offers a fresh perspective on the complex relationship between debt and financial stability. The book is meticulously researched, drawing upon a wealth of historical data and economic analysis to support its arguments. Schularick’s writing is engaging and accessible, making complex economic concepts easy to understand for readers from diverse backgrounds.

One of the strengths of the book lies in its ability to bridge the gap between academic research and real-world implications. Schularick’s insights are not only theoretically sound but also highly relevant to policymakers, investors, and anyone concerned about the stability of the global financial system. The author’s call for a reevaluation of our approach to debt is both timely and compelling, particularly in light of the recent economic upheavals and the ongoing challenges posed by the COVID-19 pandemic.

However, some readers may find the book’s tone to be somewhat pessimistic, as Schularick paints a sobering picture of the risks associated with excessive debt. While the author does offer some suggestions for mitigating these risks, the overall message can be unsettling for those seeking a more optimistic outlook on the future of the global economy.

Nonetheless, “Leveraged” is an essential read for anyone seeking to understand the complexities of modern finance and the challenges we face in ensuring a stable and sustainable economic future. Schularick’s insights are sure to spark important conversations and debates among economists, policymakers, and concerned citizens alike.

Recommendation

Inspired by the disruptions caused by the 2008 financial crisis and the COVID-19 pandemic, this collection of essays offers an engaging overview of the latest thinking in economics and its practical implications. Many of the conclusions presented here question the pre-2008 assumption that financial systems will be just fine, as long as free markets and private incentives prevail. The work of the late, great Hyman Minsky – who explained human nature’s tendency toward boom-and-bust cycles – is a recurring theme and inspiration. Edited by professor Moritz Schularick, this notable book shows how credit and leverage are fundamental factors in recent crises.

Take-Aways

• Credit booms distort economies, and economic slowdowns inevitably ensue.
• The “agency” issue revealed by the 2008 financial crisis shows that both executives and their shareholders take risks underwritten by the taxpayer.
• Investors, not subprime borrowers, played the major role in the 2008 US housing market crash.
• A banking system with higher capital-to-lending ratios does not affect the likelihood of a financial crisis.
• Financial sector expectations drive lending booms and busts.
• Investment industry methodology could improve the process of ascertaining the riskiness of banks.
• Studies highlight the link between credit growth and the lowering of the price of risk.
• A comprehensive historical categorization of financial crises is a valuable exercise.
• The US Great Depression may have been a credit boom gone wrong.
• Although credit plays a big role in creating financial instability, its policy implications are far from straightforward.

Summary

Credit booms distort economies, and economic slowdowns inevitably ensue.

The current regulation of the financial system is too focused on minimizing the risk of banks getting into trouble. The biggest impact of financial crises lies in the accompanying dramatic drop in consumer spending and loss of confidence in the wider economy. Sharing the risks of the fallout when the economy turns would be a better approach.

“The current structure of banking regulation does not split risk between creditors and debtors in a socially beneficial manner.”

One crucial way to tackle this would be the use of “state-contingent contracting” (SCCs) in which, during a downturn, contracts automatically reduce the amount a borrower needs to pay back. Examples of SCCs already in use include student loans in which the payback is contingent on the borrower’s earnings, as well as loans to countries in which the repayment depends on GDP growth. A crucial SCC policy would be a “shared responsibility mortgage” (SRM), whereby homeowner repayments would reduce when house prices fell.

Credit booms distort a country’s economy, as more labor, business capital and private credit go toward real estate, construction and domestic consumption, and imports increase. Meanwhile, rising domestic costs make exports less competitive, and consumption-driven sectors are less able to generate productivity gains than export sectors. Credit booms are statistically followed by declines in GDP.

“Such booms are instead often episodes when credit expands for reasons unrelated to economic fundamentals, and where the expansion generates distortions and vulnerabilities that often end in crisis.”

When the boom ends, wages need to fall in certain areas, and people should be working in different sectors to better reflect underlying fundamentals. But rigidities and frictions mean the adjustment takes time, prolonging the slump. One example of this kind of distortion is the high number of people working in the construction sector before 2008 in the United States.

The “agency” issue revealed by the 2008 financial crisis shows that both executives and their shareholders take risks underwritten by the taxpayer.

During the bank bailouts after 2007, the decisions and incentives of senior bankers came under scrutiny. Further studies into bankers’ actual behavior reveal that the professionals genuinely believed that their actions and decisions were in their shareholders’ interests. Yet studies of how bankers managed their personal share options and investments show that they kept their own financial “skin in the game.”

“The bigger agency problem during the last financial crisis was between management and shareholders on one side and the government as a stakeholder on the other.… Implicit or explicit government bailout guarantees can make it optimal for shareholders to make banks more risky than is socially desirable.”

The more legitimate concern is that executives and shareholders were both gaining a moral-hazard type of benefit by pushing risk and profits to the maximum. They knew that taxpayers would bail them out if their risk-taking blew up. One damning finding is that many banks made large dividend payments to their shareholders before and during the crisis. In the absence of the reassurance of bailouts, prudent banking instincts in shaky times should have meant building up reserves. These findings suggest a case for creating “lock-ups” or “debt-based compensation” for bankers’ pay. This would set the condition that there not be bankruptcies or a taxpayer bailout for some time after the remuneration period. Even then, it’s still possible that optimistic shareholders could put pressure on executives to “swim with the tide” during a boom period.

Investors, not subprime borrowers, played the major role in the 2008 US housing market crash.

Excessive subprime lending provided a popular narrative that cut through the complexity of the 2008 US financial crisis. But when studying the mortgage holders who fell into arrears, a telling difference appears in the behavior of those who were investors, categorized as those owning three or more properties. The typical non-investors displayed a varying pattern of mortgage delinquency and payment recovery. They sometimes cured the delinquency, but they also often had other non-real estate loans in distress.

“The fact that it is real estate investors that drove the foreclosure crisis leads to policy implications that are very different from those enacted based on the notion that the crisis was driven by subprime borrowers.”

By contrast, the investors, who were often young professionals, showed no signs of having other loans in distress. Their delinquencies were often swiftly followed by outright foreclosures, suggesting strategic defaults. Data reveal that these investors were approximately 14% of all borrowers, but they represented almost 50% of foreclosures during the crisis’s peak. To provide assistance to mortgage holders in a crisis would, in this light, seem both ineffective and not a fair use of taxpayers’ money.

A banking system with higher capital-to-lending ratios does not affect the likelihood of a financial crisis.

In the response to the 2008 crisis, a call arose for banks to maintain stronger capital ratios. Despite regulations increasing capital after previous crises, and despite rising capital ratios leading up to 2008, the problem still occurred. No evidence suggests that banks with more capital suffered less in that period. Overoptimism, not a lack of skin in the game, better explains banks’ excessive risk-taking. However, research shows that better capital ratios do make a difference to the recovery from a crisis. Countries where banks had below average capitalization clearly had slower economic recoveries.

“Vigilance needs to rest on a variety of other indicators, two of the most important being the growth of credit relative to the economy, and the funding mix of the banking system – in particular, reliance on outside short-term wholesale funding.”

Starting in the 1970s, the funding side of banks’ balance sheets became less and less fulfilled by customer deposits, which have shrunk to 50% of funding. With capital equity being fairly constant, “outside funding” is now filling the growing gap. It’s possible to argue that while regulation has focused on capital ratios, the area of outside funding is where risks have quietly accrued in banking.

Financial sector expectations drive lending booms and busts.

Major mainstream theories regarding how financial markets work assume that free markets, made up of rational actors, will reflect the true comparative values of returns and prospects. However, studies confirm the instincts of many observers that actors in the financial sector systematically amplify the trends of the recent past and thereby neglect the mean reversion that long-term data suggests.

“The extrapolative tendencies in expectations can be important for understanding credit cycles and help explain why credit booms and excess lending may arise in good times, sowing the seeds for subsequent crises.”

While external shocks might trigger a change in sentiment, it’s the expectations-overshoot dynamic, which eventually causes losses due to excessive investment, that ultimately precipitates booms and busts. In the long-term data, periods of high credit growth are followed later by periods of low profit returns and low bank equity returns. Pessimistic expectations can be just as significant, as US house prices after 2008 illustrate.

Investment industry methodology could improve the process of ascertaining the riskiness of banks.

As recent crises demonstrate, ascertaining the actual risks that banks are exposing themselves to is an imperfect science. A portfolio-assessing methodology, used as a best practice in the investment industry, could be a useful tool. Banks have some discretion over when to acknowledge some kinds of unrealized valuation changes. They have incentives – including paying managers’ compensation, maintaining share prices and meeting capital standards – to keep up the recorded values of their assets for as long as possible.

“The portfolio mimicking approach combines both market data and bank accounting data in a useful way to make progress on this question. The resulting risk measures are transparent, additive, and can be used to subject banks, their positions, or the entire system to various adverse scenarios.”

Studying the 2008 crisis reveals that some banks tweaked the way they valued their assets in their favor, and they were slow to adjust values downward. The book equity metrics of some banks conspicuously obscured the impact of the 2008 crisis. Similar to the exercise of regulators now stress-testing banks, “portfolio mimicking” – measuring bank risk based on capital market performance – provides enhanced ways in which different risks can be calculated and interpreted.

Studies highlight the link between credit growth and the lowering of the price of risk.

Credit spreads are the difference in interest rates or returns between safe and risky investments. In boom times this spread gets smaller, as risk aversion goes down, sometimes to the point where it has decoupled from the fundamentals involved. In contrast, during and shortly after financial crises, the spread widens, as risky investments need to increase their returns to maintain their attractiveness. Safe choices like bonds become more attractive, lowering the return they need to offer.

“Because low asset volatility in part predicts credit growth, a potential explanation is that agents update their views on risk based on the past and are overoptimistic about risk going forward. This could lead them to take excessive risk, resulting in fragility and raising the future likelihood of a bad event.”

Results of studies show that low risk in the recent past encourages more risk-taking or a neglecting of risks, leading to overinvestment. This is more significant as a factor than high past returns. Studying credit spreads over a long period can roughly predict an ensuing financial crisis. But that is not to say that evidence of mispricing is easy to define, and it sometimes only appears clearly in hindsight.

A comprehensive historical categorization of financial crises is a valuable exercise.

With financial crises still happening, the task is to comprehensively log and categorize the many financial and banking crises throughout history, in as many countries as possible. The aim is to have a more quantitative approach by focusing on real-time metrics, like bank equity returns, credit spread measures, credit distress metrics, nonperforming loan rates and other bank data. Government policy responses can also be categorized. This quantitative approach is in contrast to the vagaries of how commentators report on financial crises at the time, and to how narratives are filtered by subsequent historians.

Narrative accounts of crises are still a valuable source of knowledge, when complemented and validated by empirical evidence. Research reveals that some “quiet crises” with less impact on the general economy have been forgotten, while others are misunderstood or built up to a disproportionate degree. The study highlights that the spread of government-backed deposit insurance was a game changer, along with the general shift from lending to businesses to lending for real estate.

The US Great Depression may have been a credit boom gone wrong.

The Great Depression remains the most dramatic and iconic economic crisis to study. As popularized by economist J. K. Galbraith, the role of credit in generating the bubble was critical, including how stocks were bought on margin, which was later made illegal. House prices also rose, especially in and around some cities like Chicago, thanks to migration from struggling farms. The growth of the money supply continued until 1926, but credit growth continued after this for a few manic years. Rising asset values allowed bank balance sheets to seem fine, but liquid reserves were shrinking. As a proportion of nominal GDP, total private credit reached 156% in 1929 from 113% in 1912, more than that of other developed countries.

“The New York Fed pressured its member banks to cap brokers’ loans. They obeyed, but the interest rates on brokers’ loans proved so attractive that nonmember banks, other financial institutions, companies and individuals filled in the gap almost without halt. The flexibility of the market thwarted the regulatory effort.”

There was little inflation to lead the Federal Reserve to raise interest rates, but when it did so in 1928 to contain the boom, the stock market continued to rise, even attracting money from abroad. The Fed pressured member banks to limit loans offering leveraged stock market investment. But in the last few years of the boom, most margin loans came not from banks but from investment trusts and nonfinancial corporations, some 14% and 56%, respectively. Free market profit-seeking ingenuity was outflanking government efforts to restrain the credit boom, suggesting the need for alternative macroprudential policies. In the post-World War II period, credit bubbles were not an issue in business cycle downturns, but since the 2008 crisis, the importance and study of their role has revived.

Although credit plays a big role in creating financial instability, its policy implications are far from straightforward.

Evidence suggests that the allocation of credit matters as much as its quantity, and excessive credit directed toward real estate is more likely to come before a financial crisis than is credit directed to corporate investment. Sectoral shifts toward real estate may signify a lowering of lending standards or an asset bubble forming. The Asian financial crisis of the late 1990s illustrates this: In the years preceding the crisis, lending shifted away from agriculture and manufacturing, and toward real estate and construction.

“Credit booms that end in busts are not created equal. Growth in housing-related debt…seems to be among the more frequent precursors of financial turmoil.”

Because real estate is a sector with very long-term loans and durable capital, it’s more responsive to low interest rates than other credit areas. But any government policies trying to limit these credit waves going into real estate and construction are at risk of being victim to subjective political influence. Simple macroprudential policies are, in the end, more desirable.

About the Author

Moritz Schularick is a professor of economics at Sciences Po in Paris and the University of Bonn, Germany. The authors of the sections are associated with the Institute for New Economic Thinking.