Friday, February 26, 2010

Leverage and Risk

Leverage alone doesn't cause recessions, so there is no problem with leverage, right? No. Leverage increases the risk of recession due to an unexpected shock, and adds rigidity to the economy making it more difficult to deal with the result. Leverage is often the symptom of other serious problems such current account imbalances due to mercantilism, or an unwillingness to face the real risk of investing for the future, or subterfuge in submerging real risk beneath the surface. Investors may prefer a lower exchange rate, or saving to investing, or the illusion of risk avoidance, but these are not necessarily in the interest of the country or the economy as a whole. Investor preferences are often the result of government policies themselves, so we need to make sure what we encourage is what we want.

Leverage is a tool and not good or bad in itself. One should expect leverage to grow with more productive opportunities and the income to support it and diminish with fewer of them and reduced prospects. One must be extremely cautious of leverage for other purposes, such as for currency manipulation, or to increase consumption or speculation. Increasing leverage is expansionary while decreasing leverage is contractionary. There can be real dangers to our economic financial well-being due to leverage and risk.

harply increasing leverage demands negative real interest rates to combat it, more inflation, but increasing asset prices can cause bubbles and keep real interest rates too high until they burst. Trying to avoid risk by shoving it onto government isn't avoidance at all. Unless we really want the socialist paradise where government is the only equity owner and everyone else can be debtors and lenders, it is in public policy to discourage it.

1 comment:

請吃飯 said...

Circumstances are the rulers of the weak, instrument of the wise.........................................