If you give people money to buy things, they’ll buy more than if they are using their own money. The less skin in the game, the more risk they will take. That’s the essence of what Yale economist John Geanakoplos calls “leverage cycle” theory. An article in the Wall Street Journal last week details how lowering collateral obligations in key categories like mortgage financing helped to drive prices of assets during the recent housing bubble.
The consequences of the leverage cycle are easy to see in the tightness in the mortgage market, which has significantly changed the character of the home buying market. If economists conclude from this economic devastation that collateral coverage against leverage will need to be broadly controlled, and these conclusions are institutionalized into the financial system, we will enter into a long period of constrained returns and very slow appreciation of asset values, not only of houses, but of every other class of asset.
It’s an underlying contradiction of the financial marketplace: Risk drives returns, but too much risk destroys markets.