David Warsh knows how to spin a yarn about economics and economists. His latest post features John Geanokoplos of Yale and the waves he has been making in academic and policy circles with his work on "leverage cycles." His ideas have been around for a while, but Geanokoplos says they have caught on only recently:

“After it was finally published, as “Liquidity, Defaults and Crashes” in the conference volume in 2003, I gave that Seattle paper at every major university.  It was exactly about the liquidity cycle, but it didn’t really catch on,” Geanakoplos recalled last week. The time for it wasn’t ripe. The Asian financial crisis had been contained. No lender lost a dollar when LTCM failed. The consequences of the dot.com crash had been confined mainly to the stock market. For the next seven years, business as usual resumed. “This time they are more interested.”

Here is the fundamental insight, according to Warsh:

a single loan requires not one but two terms to be negotiated, and that one may become much more important than the other in certain situations was clear enough to Shakespeare four hundred years ago. Wrote Geanakoplos: “Who can remember the interest rate that Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed upon as collateral. The upshot of the play, moreover, is the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral –a pound of flesh but not a drop of blood.” Thus did the The Merchant of Venice end happily, not with a cramdown, but with very different terms if the loan were to be foreclosed.

The trick, Geanakoplos says, is to recognize that the tendency to increasing leverage is part of the process – and that collateralization generates bigger and bigger effects on assets prices as the cycle rolls on, until, in due course, for one reason or another, participants eventually become uneasy with the situation, and the cycle comes to a crashing halt.  To reduce the foreclosure mess (the paralyzing bad news in the current situation), he recommends Fed-mandated principal write-downs for non-prime borrowers whose loans are underwater. To stop the de-leveraging, he says, the Fed should prop up leverage at moderate levels, even if the market demands more collateral.  To replace the natural optimists who have gone broke, the government must step in and do some buying.  That’s what the Troubled Assets Relief Program was for. And the market has been buoyed recently by the prospect of more of the same. But if the anticipated TARP II is not forthcoming, he says, the rescue effort probably back again.

So add John Geanakoplos to the (short) list of economists we should all have been listening to more intently (Bob Shiller, Nouriel Roubini, Raghu Rajan, ???).

Read more at Dani Rodrik's Weblog