The Leverage

Megan McArdle’s charticle on the collapse of the Icelandic economy contains this text:

Notably, Iceland’s financial industry had little exposure to American subprime mortgages. In this, Iceland serves as an important reminder: ultimately, leverage, more than houses, is to blame for the severity of the international financial crisis. And leverage is what regulators worldwide will need to tackle as we seek to clean up the mess.

Kevin Drum makes a similar point here:

[T]he housing bubble underlies everything (though it might not next time….), but the financial rocket science really did kick everything into another gear.

Rocket science being, in this case, mostly ways to increase leverage.

In this vein, it’s worth observing that asset bubbles are a surprisingly common and robust phenomenon. You see them in simulations all the time, as well as in the real world. A big part of the issue is that just because some asset class is clearly overvalued, that doesn’t actually make betting on a price decline a surefire thing. Housing was (somewhat) overvalued related to long-term trends in 2002, but at that point prices were still much closer to the long-term trend line than they were to the peak. Under the circumstances, a bet on rising home values could be a big winner notwithstanding the fact that values were too high. And that’s the general nature of the asset bubble. The mere fact that I see we’re in a bubbly situation doesn’t mean it’s wrong for me to bet on further price increases. As long as I think you think further increases are likely, then it may make sense for me to buy. But then if some third guy realizes that I’m going to buy whether or not I think the assets are fundamentally overvalued, maybe he decides to buy soon. Next thing you know, the bubble can keep on inflating for a while even if everyone thinks prices are too high. Like Wile E. Coyote we can keep on running until someone looks down.

So under the circumstances, the mere fact that at asset bubble emerged shouldn’t shock us. But we do want to contain the damage done when bubbles burst. And containing leverage seems like one important way to do that.