Fixing the crisis: Two systemic problems

Axel Leijonhufvud 12 January 2009



Greed was not invented yesterday. So, contrary to much recent political commentary, greed does not explain how we got into our current difficulties.

We depend on the greed (self-interest) of people to deliver our daily bread and much else besides. It serves the common good even when that is “no part of [their] intention” as Adam Smith said. And we depend on competition to chastise those who do not do a good job of it. This harmony of self-interests is what markets are supposed to do for us.

All that does not seem to have worked as it is supposed to in the financial markets. So what is wrong?

Bread markets and financial markets: negative and positive feedback mechanisms

The market for bread is stable. If demand exceeds supply, the baker bakes more. If his inputs get more expensive he raises the price and some customers consume less bread. Simple, sensible rules of behaviour suffice to coordinate the actions of consumers and bakers. The bread market works on the negative feedback principle like a thermostat controlled air conditioning system or an automatic pilot.

The world of finance is a multidimensional system. In most dimensions, it works like the bread market, i.e. with negative feedback mechanisms. But in two important dimensions it does not. Market forces do not stabilise:

  • The general price level under present monetary arrangements, nor
  • The overall level of leverage in the financial system.

Both are unstable and subject to positive feedback processes. Movements of the price level – inflations or deflations – tend to be self-reinforcing. So do movements in leverage.

Two consequences follow.

  • The price level must be stabilised by monetary policy.
  • Leverage needs to be constrained by regulation.

The price level and failed inflation targeting in the US

In the days of metallic standards, the price level was ultimately determined by the demand and supply of monetary metal. The system could be imitated on a fiat standard. Not so long ago monetarists still explained the equilibrium of the price level in terms of the demand and supply of money. Reserve requirements imposed on the banks and the public’s slowly changing habits with regard to the use of paper currency together with the central bank’s control of the monetary base determined the supply. Today, the reserve requirements are essentially gone, substitutes for the use of currency have proliferated and the monetary base adjusts to the demand for it. What this means is that the price level has lost any quantitative anchor. It is no longer determined by market forces.1

Although the price level no longer has a market-determined equilibrium, the central bank can use the interest rate to govern the direction in which it is changing. Set the rate below a certain value and prices should rise; above it, and they should fall. Find just the right rate and the price level should stay constant. This is what the policy strategy of inflation targeting was supposed to achieve.

However, the inflation targeting policy doctrine failed in the US

The Federal Reserve’s policy of keeping the federal funds rate extremely low helped engineer the recovery from the collapse of the boom. In the ensuing years, US consumer prices stayed within the Fed’s inflation target range. This seemed to indicate that they had found the “right” level for the interest rate. But the stability of consumer prices was misleading. Inflation was in fact kept in check by the policies of a number of countries intent on keeping their currencies undervalued vis-à-vis the dollar so as to maintain their exports of consumer goods to the American market. American prices were kept from rising by competition from these imports.

Hence, the Fed was misled into keeping interest rates far too low for far too long. It was running what was in effect an extremely expansionary monetary policy – although it did not produce CPI inflation. What it did bring about was asset price inflation, most notably in housing and real estate, coupled with a very serious deterioration in the quality of credit in the system.

Leverage: Markets and the madness of crowds2

When leverage is rising all around with everyone buying on credit, everyone is also merrily making money. Profits reinforce the process. Meanwhile, securitisation of loans and credit default swaps serve to obscure rising risk. Competition forces even those firms and individuals who realise that risk is rising to follow along or else be pushed out of the game altogether. A loan officer who does not lend, a risk manager who does not go along, a manager whose bank branch does not grow will all be under threat to lose their positions. The pressure to run with the herd becomes hard to resist. In this stage of the process, opposition to government interference with “free enterprise” will be fierce and almost universal. But risk is constantly increasing and the financial system as a whole becomes steadily more fragile until eventually it is so fragile that when it finally breaks it can be difficult to identify what exactly made it happen.

The simple arithmetic of the banking crisis

Some simple arithmetic helps illustrate what is going on. Consider, as an example, a bank which uses $1 billion of capital and $24 billions of borrowed money to invest in $25 billions worth of assets. Its leverage ratio (debt/equity) is 24. That is high but not extraordinary in recent years. All five of the big American investment banks3 had higher leverage ratios than this at the end of 2007. Many big European banks exceeded this ratio and hedge funds often operate with still higher leverage.

Even if the rate on its assets exceeds that on its debt by only 0.5%, the bank would earn a rate of return on equity somewhat in excess of 12%. When competition from other financial institutions compresses this margin between the rates on assets and on liabilities, the bank has two strategies available by which it can maintain the rate of return on equity that its investors may have come to expect. Both give rise to self-reinforcing, positive feedback processes which serve to grow a bubble.

  • Increase leverage further4.
  • Shift into riskier asset classes promising higher margins.

Of course, these margins too will come under competitive pressure. Thus the recent boom ended with leverage ratios at historic highs and risk premia at historic lows.

But the riskiness of high leverage is as obvious as its profitability. Suppose 20% of the bank’s assets were in mortgages or mortgage-backed securities and that it incurred a 20% loss on them. A decline of just 4% in the market value of its asset portfolio would render the firm insolvent – and would cause it to go bankrupt if it was forced to use “mark-to-market” accounting which would reveal its condition for all to see.5 The ultimate collateral for mortgages and mortgage-backed securities is of course the market value of the housing stock that they have been used to finance. As of August 2008, the Case-Shiller 10-city index of house prices is about 18% below its value of a year earlier and 22% below August of 2006.6

What causes markets to “freeze”?

August 7, 2007 has become the date generally accepted as the day the crisis hit. It was not the day that problems first began to reveal themselves. There had been trouble in American housing and mortgage markets going back to the previous autumn. But on August 7, the interbank market “froze.” The banks would not lend to each other. This was virtually unprecedented – something that market participants had not experienced before.

For more than a year since, the interbank market has flickered on and off at varying volume but has not properly “unthawed”. Moreover, the phenomenon of “frozen” markets have become commonplace , affecting ordinary commercial paper, mortgage-backed securities and other collateralised debt obligations, auction rate securities, and so forth. Central banks have struggled mightily to restore liquidity to money markets but with little success.

The simple leverage arithmetic above suggests what the problem is. The banks were highly levered and held huge amounts of mortgage-backed securities. The ultimate collateral behind these securities was rapidly losing value as house prices fell. Defaults on mortgages were rising as were defaults on auto loans and credit cards. The variety of novel collateralised debts and risk transfer instruments made the precise situation of potential counterparties non-transparent to the individual financial institution. But many institutions knew themselves to be on the brink of insolvency and knew their own balance sheet to be fairly typical. For a bank to lend to a counterparty that might go bankrupt the next day could easily endanger its own survival. So the market “froze.”

Conventional monetary policy can relieve a situation of illiquidity in the markets. It can do very little to “unthaw” markets among institutions tottering on the brink of insolvency. Just lowering the central bank interest rate accomplishes very little. The impotence of traditional monetary policy explains the spectacular array of improvised and extraordinary measures tried by the monetary authorities in the US and in Europe during the last 15 months.

From Wall Street to Main Street: Financial deleveraging and the real economy

Once the boom breaks, the thundering herd stampedes in the opposite direction. Everyone attempts to protect himself by reducing leverage. Losses pile up on all hands. Everyone wants out but few can escape. Before long, all the institutions that a few months earlier wanted no interference with the “free market” call on government to pick up the pieces.

The logic of deleveraging is simple. There are three ways for a firm or an individual to deleverage.

  • Attract new capital so as to increase the denominator of the leverage ratio.
  • Sell assets and use the proceeds to pay down debt.
  • Spend less than current income and to use net cash flow to reduce debt.

What works for a single entity does not necessarily work for the entire banking system or for the private sector as a whole. Attracting outside capital is “nice work if you can get it” but the impressive sums that US banks managed to raise from sovereign wealth funds and other foreign sources proved no more than drops in the bucket in the end. The last resort, therefore, became government “bail-outs”, ultimately funded by the tax payer.

The other two ways of reducing leverage are dangerously destabilising when too many economic entities are striving to do so at the same time.

If, for example, several banks were to sell the same type of assets in order to pay down debt, the price of the asset would fall and the proceeds of sales might well be so low that the net result is a further increase in their debt-to-equity ratios. This is another example of positive, self-reinforcing feedback. In this instance, it makes the situation worse.

Naturally, the big financial institutions do their utmost to avoid being caught in vicious circles of this kind. When they cannot find buyers for assets at prices which would help them reduce their leverage, the markets are said to be “frozen”. With no transactions, there are no recorded market prices. The assets on their books, the banks will then argue, cannot be “marked-to-market” for accounting purposes, but have to be “marked-to-model”.7 This is a temporising tactic, allowing the banks to temporarily avoid reporting losses and, in extreme cases, not to reveal insolvency. The authorities tend to go along with such evasion out of fear of the secondary effects of insolvency of large institutions. A large volume of more or less “toxic” debt supported by highly leveraged institutions is hanging over the markets. An avalanche of insolvencies would be devastating.

The third way to deleverage is to spend less than you take in. For financial institutions this means not relending the funds flowing back in the servicing of loans but using them instead to reduce debt or build up cash reserves. When the banks are all operating in this mode, businesses and households find ordinary commercial or consumer credit to be simply unavailable.

When everyone in the non-financial sector tries to spend less in order to pay down debt, the net result is simply that everyone’s revenues decrease and the more so the harder they try. The drop in income then reduces their ability to service debt. Beyond that, the attempt on all hands to buy less and sell more puts pressure on market prices in general. In the worst case, this can produce true “debt deflation” – a process whereby the general attempt to reduce debt leads to a fall in prices that raises the real value of outstanding debt. This is the most dangerous of all the positive feedback processes set in motion by a financial crisis. The US and Europe has not experienced debt deflation for the last 75 years, but it has been a looming threat for the last several months and it is still too early to say whether the danger has been definitively averted.

The decline in asset prices resulting from financial deleveraging will come to affect also reproducible assets – in the present situation particularly (but not only) house prices. The production of these assets will fall, therefore, and so will employment in construction and capital goods producing industries. American households are also fairly highly levered at this time and virtually the only way for them to reduce debt is to increase their saving. The fall in business investment combined with the increase in attempted saving by households will, under present financial conditions, produce the kind of recession that John Maynard Keynes theorised about. The automatic adjustment tendencies of free markets are peculiarly ineffective in producing a recovery from a recession of this type.8

1 See Axel Leijonhufvud (2007a), “The perils of inflation targeting”,, 25 June 2007 and (2007b), “Monetary and financial stability”, CEPR Policy Insight No 14, October 2007.
2 Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay (London 1841) provided famously vivid accounts of three early forerunners of our present troubles: the Mississippi bubble, the South Sea Bubble, and the Dutch Tulip Mania.
3 A vanishing species! Of the big five, Lehman Brothers went bankrupt; JP Morgan Chase, with some Federal Reserve assistance, absorbed Bear Stearns as did Bank of America with Merrill Lynch; Morgan Stanley and Goldman Sachs changed into bank holding companies so as to be eligible for Federal Reserve credit.
4 Deposit-taking banks which normally should not operate with leverage ratios in the double digits may yet do so indirectly by spinning off off-balance sheet entities such as the special investment vehicles (SIV’s) located in the Cayman Islands or some other place outside the reach of US regulatory agencies.
5 Mark-to-market accounting was generally accepted and used as long as all markets were going up. Managers could claim bonuses proportional to the capital gains that this accounting convention showed. Many became quite rich. Since the credit crisis broke, financial firms have tried to escape mark-to-market accounting as far as possible and regulators have not insisted on it out of fear that it would immediately reveal widespread insolvencies and pose the danger of an avalanche of bankruptcies.
6 The decline in house values is far from uniform across the country. For the Los Angeles metropolitan area, for example, the August 2008 value of the index is 26.7% below August 2007 and 31% below August 2006.
7 The models are internal to the institutions in question. In some instances, they have been criticised as “marked-to-myth”.
8 Leijonhufvud (2008) “Keynes and the Crisis”, CEPR Policy Insight No. 23, May 2008




Topics:  Financial markets

Tags:  inflation targeting, financial crisis, leverage

Professor of Monetary Theory and Policy at the University of Trento, Italy and Professor Emeritus, Department of Economics, UCLA


CEPR Policy Research