Credit & Leverage – The Fulcrum Of The “Loose Joint” Launching Booms & Busts

Hayek identified money and the institutions it gives rise to as the “loose joint” of the economic system.  Money and finance are the massive pivot points that allow the coordination system of the market to spend years getting itself twisted all out of joint, producing unsustainable booms that “snap back” in predictable and fully inevitable busts.

More specifically, some part of Hayek’s work in macro is an effort to chart how credit and leverage can send the economy into unsustainable disequilibrium across the intertemporally coordinated structure of production, profits and consumption, radically upsetting the economic vs. non-economic status of all sort of productive inputs –  from dedicated capital goods to marginal land or resources to specific labor skills.  At the point of “snap back” the whole of the economy is thrown into what economist Arnold Kling calls a “recalculation”:  the whole structure of relative prices and production activities is out of whack, and a great many specialized inputs (like specialized labor) find themselves groping about for position of positive — rather than negative — economic value in the newly re-ordered structure of production processes and prices.

Work at Yale by economist John Geanakoplos is putting fresh meat on Hayek’s “loose joint” story of the economic cycle.  Take a look at these graphics:

Leverage & Loose Joints

The economic story Geanakoplos tells is the tale of how the financial industry succeeded in expanding the size of the “loose joint” of credit and leverage, at once compounding the size of out-of-coordination joint twisting and concentrating a good portion of it in specific sectors of the economy and on specific balance sheets — many of them “too big to fail”.  Or “too politically connected” to be left holding the bag.

ht Donald Marron.

Hayek’s early explorations of the credit / bubble / profit / leverage cycle can be found in his Monetary Theory and the Trade Cycle.