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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

The Theory of Natural Buyers



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Marginal Revolution points me to Mark Whitehouse’s excellent Wall Street Journal article on Yale economist John Geanakoplos. Apart from Whitehouse’s problematic oversimplification of rational expectations, it is well worth your time.

In a 2000 academic paper, Mr. Geanakoplos offered a theory. He said that when banks set margins very low, lending more against a given amount of collateral, they have a powerful effect on a specific group of investors. These are buyers, whether hedge funds or aspiring homeowners, who for various reasons place a higher value on a given type of collateral. He called them “natural buyers.”

Using large amounts of borrowed money, or leverage, these buyers push up prices to extreme levels. Because those prices are far above what would make sense for investors using less borrowed money, they violate the idea of efficient markets. But if a jolt of bad news makes lenders uncertain about the immediate future, they raise margins, forcing the leveraged optimists to sell. That triggers a downward spiral as falling prices and rising margins reinforce one another. Banks can stifle the economy as they become wary of lending under any circumstances.

The policy upshot dovetails with calls by Nicole Gelinas in her excellent After the Fall for demanding uniform capital requirements.

This idea had big implications for policy makers. For decades, they thought of interest rates as the most important indicator of supply and demand in credit markets, and the only variable they needed to adjust to achieve a desired economic result. Now, Mr. Geanakoplos was saying that something else — lenders’ collateral or margin demands — could be even more important.



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