Financial Theory: Lecture 26 Transcript
December 10, 2009
Professor John Geanakoplos:
What I'm planning to do today is to spend a half an hour or less just telling
you a little bit about what a new theory might be, what I call the Leverage Cycle, and then spend the rest of
the time maybe answering questions about the course that you might have. I could, if you wanted to, devote
the whole time to what the new theory is, but why don't I at least pause after a half an hour and see if you
So what is the thing that's been missing from the entire course and has been missing from economic theory, I
think, almost entirely for all these years, and certainly missing from all the textbooks that you might have
looked at during the course of the semester, and you remember there was a list of 20 books or something you
could have read, and that's the idea of collateral.
It's the idea that in order to guarantee that you're going to keep your promise you have to put up collateral,
and people just don't trust in everyone else keeping their promise, they want collateral. So if you put that into
the model what sorts of things might be different? So I want to just work out an example so you can see how
they might change.
I want to talk about an example that's going to illustrate what happened in our crisis. And I guess that it's a
little interesting that I wrote this and I presented this in 2000 at the World Congress, and it got published in
2003, so this was long before the crisis. Now, as I said, there had been other smaller crises before in 1998,
maybe '94, maybe '87, certainly '98, and of course I was thinking about these previous crises when I built this
model, but not many other people thought much of those other crises.
And as it happens, this last one that we're still at the bottom of, or a little past the bottom of, I think is very
similar to the ones we had before, but just much bigger. So here's my simple version of it.
I'm going to give two models, a very simple one with two periods and a slightly more complicated one with
three periods, and of course all the interesting things happen in the three-period case, but just to make it
simple to understand I'm starting with the simpler one.
So suppose that there's a security which I'm going to call Y that everybody holds. Why is there no chalk?
Gosh, I taught the class in here, I just finished lecturing in here with a whole box, oh here it is, a whole box of
chalk. So suppose that there's a security Y that I'm going to think of as a mortgage security, or you could
think of it as a house, or you could think of it as an oil well that has uncertain output in the next period. And
then there's going to be something like gold that I'll call X.
So this might be like gold, and this might be like a mortgage security, or like an oil well, or you might think
of it as a house, but I'll think of a mortgage security, an oil well. It's something that pays an uncertain
outcome in the future, and this is something that's very stable and you know exactly you've got gold this
period, if you just save it you'll have the same gold next period. So now people are going to differ according