Leverage and Capital Formation

Arnold Kling, reviewing Edward Conard’s Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong, mentions at least one claim where Conard is clearly defending the conventional wisdom and only pretending to be contrarian: “Financialization is good for us, because it allows risk-takers to lever up and generate more capital formation.”

If the conventional wisdom actually went against Conard on this we would have less financialization and less leverage. But the cw is clearly on his side—everything about American public policy reflects the idea that there’s a broad public interest in maintaining the technology to sustain a high degree of leverage. I’m increasingly unpersuaded by this. Not simply because the downside in terms of financial crisis is bad, but because the alleged upside in many ways looks to me like a barbarous relic of the gold standard. For a household or a firm, leverage is a useful way to (if you’re lucky) end up with a large capital investment based on a small initial pile of capital. By the same token, a large degree of leverage could help a country with a large productive capacity engage in a lot of capital formation based on a fixed supply of gold reserves. But of course the modern economy doesn’t work like that. A household has to cope with a fixed stock of money, but the United States of America doesn’t. Less leverage built atop a larger stock of currency would work just as well.

Now in theory poor countries can take advantage of leverage to help cope with systematic shortage of capital goods. But if we look in practice at catch-up growth success stories—Japan, Korea, Taiwan, China, etc.—what we overwhelmingly see is export-led growth not capital imports.

I’ll gladly believe that at some level of leverage you may have “too little” but I’m not persuaded that this worry applies at any real-world margin.