Overleverage, and a Failure of Credit

Just a brief post here.  The Economist features a simple symmetric model to try to explain cycles in the financial marketsCute model, but it can’t explain booms and busts.  The key missing feature is credit that can default.  Defaults are asymmetric.  With bonds you can make a little with high certainty, or lose a lot with low certainty.  This is true of all lending, leaving aside convertibles.

In a true bust, defaults are rampant, as badly capitalized firms fail amid weakening demand.  During booms, some  firms magnify the results by levering up (borrowing more).  This is the behavior that created booms and busts, together with the momentum effects that Brad DeLong’s model demonstrates.

Modeling in default behavior and leverage should complete the model.