Equilibrium determines leverage, not just interest rates. Variations in leverage cause wild fluctuations in asset prices. This leverage cycle can be damaging to the economy, and should be regulated. 1 Introduction to the Leverage Cycle At least since the time of Irving Fisher, economists, as well as the general public, have regardedtheinterestrateasthemostimportantvariableintheeconomy. Butintimes of crisis, collateral rates (equivalently margins or leverage) are far more important. Despite the cries of newspapers to lower the interest rates, the Fed would sometimes

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Abstract: The present crisis is the bottom of a recurring problem that I call the leverage cycle, in which leverage gradually rises too high then suddenly falls much too low. The government must manage the leverage cycle in normal times by monitoring and regulating leverage to keep it from getting too high. In the crisis stage the government must stem the scary bad news that brought on the crisis, which often will entail coordinated write downs of principal; it must restore sane leverage by going around the banks and lending at lower collateral rates (not lower interest rates), and when necessary it must inject optimistic capital into firms and markets than cannot be allowed to fail. Economists and the Fed have for too long focused on interest rates and ignored collateral.

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College Flexibility is a desirable feature of an economic system. Structural rigidities can result in sluggish growth and inflationary pressures. Many economic models, however, display considerable system flexibility because of the use of unacceptably unrealistic assumptions. The primary ‘real-life ’ features endowing the system with flexibility are unemployment and excess capacity. While realistic, unemployment is economically costly and socially undesirable. In economic theory, there appears to be a trade-off between flexibility and realism. In reality, there appears to be a trade-off between flexibility and full employment. What has not been adequately recognized, however, is the degree to which policies are available that can promote higher levels of employment--and even full employment--without resulting in deleterious rigidity.

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central banks do? ” It subsequently evolved into the background paper for my Queen’s Prize Lecture at the London School of Economics, 19 May 2003, titled “Deflation: Causes, Prevention and Cure”. I would like to thank Anne Sibert for helpful comments and Toshiaki Sakatsume for able research assistance. The views and opinions expressed are those of the author. They do not necessarily represent the views and opinions of the European Bank for Reconstruction and Development. ©Willem H. Buiter, 2003. After an absence of almost half a century, the spectre of deflation is once again haunting the corridors of central banks and finance ministries in the industrial world. While preventing or combating deflation poses some unique difficulties not present in preventing or combating inflation, deflation can be prevented and, if it has taken hold, can be overcome, using conventional instruments of monetary and fiscal policy. These include open market purchases of government securities and monetary financing of government

Flexibility is the ability of an economic system to respond to changing conditions—new technologies, new products, changes in supplies of natural resources, changes in consumer demand, and so forth. Flexible economies are able to sustain growth and high levels of employment without inflation, whereas systems that are inflexible in the face of change experience bottlenecks in production, sluggish growth, inflationary pressures, and other negative consequences. Modern capitalist economies gain much of their flexibility from the existence of unemployed resources, including labor, and excess productive capacity. Thus, flexibility, although it is a desirable feature of an economic system, may be attained at high social and economic costs. Unemployed labor increases system flexibility by providing a pool of workers from which firms can draw during expansions. The reserve pool also serves wage and therefore price stability by weakening the bargaining position of labor. However, though unemployment may bring flexibility, it causes permanent losses in potential output of goods and services, losses of tax revenues, higher government spending on public assistance, crime, physical and mental ill health, deterioration of labor skills and productivity, and more. It condemns many people to poverty and contributes to social instability. In implementing policies to maintain a reserve pool of labor, central banks, national governments, and international organizations betray the ethical and legal commitment to full employment that is embodied in many nations ' legislation and in United Nations proclamations supporting the right to work as a fundamental human right. This policy brief proposes an approach to the promotion of economic flexibility that is based on the strategic utilization of public sector activity rather than on the maintenance of a reserve pool of unemployed labor. An understanding of the role public sector activity can play in promoting economic flexibility leads to a shift in the criteria for evaluating public employment and resource use. A public service employment program benefits the economy and the society as a whole. It is compatible with high employment, high capacity utilization, and growth without the threat of inflation and, at the same time, provides socially useful public services.

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