Forget about the housing bubble; it’s the leverage.

Some business experts have been saying for months that, while the current financial crisis was probably triggered by the bursting of a housing bubble, there is a much more fundamental and difficult problem that must be solved—too much financial leverage. This paper (pdf, 5 pages plus graphs) posted by Paul Krugman today is significant because he has translated the problem, the implications, and the solution into econo-speak. Hopefully, this means that the herd of professional economists can begin to give it credence, and public policy changes can perhaps follow.

The fundamental problem is that very large global financial players, including especially secretive hedge funds, investment banks, and others in the "shadow banking system," have greatly increased their balance sheet leverage (i.e., debt to equity ratios) and have become very, very large, especially in the last 5 years or so. This resulted in an explosive creation of money that drove asset prices higher—not just residential real estate in the US, but most asset classes in most places. When prices started to drop, they had to sell quickly to try to avoid insolvency, and as selling pressure increased, prices dropped further and more rapidly, leading to the need for more selling. At the same time, institutions realized they needed to reduce their leverage for safety, which was an additional reason to sell. Not only do they have to absorb the air in the housing bubble, they also have to de-lever and reduce the amount of money in the global economy.

A special contribution of Krugman's paper is to make the case that deflation and de-levering is a global process because of the dramatic increase in cross-border asset ownership since 1995. He has this graph of US assets abroad (blue) and foreign assets in US (red) as a percent of GDP for the rest of the world.

 

The conventional wisdom had been (still is?) that a recession in a big economy like the US slows GDP in other nations because we import less. Krugman's thesis is that today the much more important driver of contagion is through the balance sheets of highly-leveraged global financial institutions. When one of these institutions decides it needs to de-lever, it doesn't just sell assets in its home nation or assets of a certain class—it sells whatever it can wherever it does business, and it stops making new commitments anywhere.

Krugman says simply increasing liquidity, as Paulson wants to do, "won't do the trick." Developed nations should cooperate to help de-lever in a different way—by putting more capital into overextended institutions. Krugman is not the first or only expert to say this, but phrasing it in econo-speak may help move policy makers.