Regulating Leverage is More Important than Regulating Bubbles

As I said yesterday, while I certainly welcome regulatory efforts to curb asset bubbles I think this is unlikely to be fully successful. What I think we really could succeed at doing is trying to ensure that if future bubbles arise they unwind more like the tech stock bubble (people who made bad investments lose money, mild recession) than like the housing bubble (massive financial crisis forces massive taxpayer bailouts, giant recession). And as Joe Gagnon writes, the key to that is to regulate leverage:

The way to reduce the cost of a bursting bubble is to reduce leverage. In a world of unleveraged (or lightly leveraged) investors, falling asset prices would not bankrupt anyone and thus would not raise fears of bankruptcy. In such a world, there are no welfare costs of a bursting bubble, at least as long as the central bank acts nimbly to keep the economy on track. It is true that investors suffer a decline in wealth, but only from a level that was not fundamentally correct to begin with. For example, the technology bubble of 2000 burst with no apparent ill effects because it was not leveraged to any significant extent and there were no government bailouts. The recession of 2001 was very mild and probably was unavoidable given that GDP was above potential in 2000 and inflation was rising. […]

The global financial crisis demonstrates the need for reforms to greatly reduce the leverage of financial institutions and to make that leverage respond to the credit cycle in a stabilizing manner. See, for example, the Geneva Report on “The Future of Financial Regulation” and the Pew Task Force statement of “Principles on Financial Reform.” Focusing on the housing market, my colleague Adam Posen also has proposed linking property-related taxes to property prices in order to damp their swings.

The bottom line is that regulators need to be vigilant in maintaining the process of deleveraging and preventing any new buildup of leveraged asset purchases, including for commodities. In the long run, we need to greatly reduce the degree of leverage in our financial system and it may be a good idea to make leverage respond inversely to asset prices and to put stabilizing mechanisms in the tax system.


Right on. Except nobody seems to be doing anything about this. Not doing it is too good a deal for the banks, too good a deal from jurisdictions that like to collect taxes on giant banker salaries, and seems to strike populists as less interesting than talking about Glass–Steagall. The risks of excessive leverage have not only been clear for over a decade, but the powers that be even acknowledged the problem and then just kind of moved on as soon as the bailing-out was done and attention drifted elsewhere.