Leverage, collateral, default and other fundamentals

A good friend recently pointed John Geanakoplos’ (JG) writings to me on endogenous leverage and default. One of the main points JG makes is that leverage and default are topics by and large ignored in economics textbooks. An amazing fact considering how crucial a role lending and borrowing plays in the real economy. The main idea is that instead of just looking at interest rates one should be looking at collateral i.e. the ratio of the down payment to the loan you get for it. JG argues that if for example your down payment is insignificant the cost of you walking away from your home and your mortgage is insignificant making it more likely to do so. This may lead to the formation of bubbles etc. JG argues that leverage and collateral should be part of the standard macroeconomic model.

In fact JG came up with the idea to examine models of leverage and default as a result of his involvement in the real  world. Looking at the trajectory of a middle of the road academic economist we will see high school being followed by undergraduate studies which is followed by a PhD which is followed by a post doc of some kind and finally an academic position. Nowhere will we see a job! I mean a real job, in the real world which will help shape this persons view of the economy in a way concordant with reality and hence different than the textbooks and research they’ve been reading which were written by people who had never held a real job either. This has got to be the explanation of why something as fundamental as leverage and default are not part of the standard academic curriculum or of the standard macroeconomic model. You end up having economists who never spent time in the economy they are supposed to be writing about. Economists, instead, are more likely to be people with an affinity for math but no real drive to actually do real math. They end up doing the brand of economics we know about: most of it is secondary literature of esoteric debates with little significance and even less relevance to the real economy.

To be fair mathematics has a similar deficit. The masters of the past used to hold real jobs and get their mathematical ideas from real problems in the real world. Most of the mathematicians today are just that: academic mathematicians. Their view of mathematics is very restricted and very far away from Physics were the origins of most of mathematics we know about are to be found. In fact this mathematician is guilty of the same ignorance: I was never taught and never knew a sufficient amount of the physics behind the mathematics I learned or the mathematics I wrote.  The difference between mathematics and economics starts where economists think everything they write about has a “policy implication” and a conclusion on what to do with people’s lives.

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