Lesson of Leverage

Time respects no person
And what you lift up must fall
They're waiting outside
To claim my crumblin' walls
--John Cougar Mellencamp

In the economic context, leverage is borrowing resources to live larger in the present than one otherwise could. Anyone carrying debt is leveraged to some degree.

Borrowed resources are employed now with the promise to pay them back later--usually with interest. Leverage thus entails risk--there is a chance that resources borrowed today cannot be paid back tomorrow. That risk may be borne by the borrower, the creditor, some combination of the two, or, as was made clear during the recent credit crisis, the public at large.

During the recent credit debacle we learned that the risk associated with leverage can be quite latent. Leverage was building in the system for years as credit was made easier. Government, organizations, individuals all levered up.

Early on, things seemed fine. In fact, higher near-term standards of living facilitated by leverage created the illusion of prosperity. "New era" claims abounded. "Housing prices can only go up..." "Policymakers have our backs..." Collective optimism increased which drove leverage to greater heights.

As we now know, there was no new era. The prosperity was a mirage--a state of borrowing from the future to fund higher living in the present.

At some point the mirage disappeared. Collective risk appetite declined. Incomes did not permit repayment of debt. Credit spigots closed. A downward spiral insued as the potential for loss associated with leverage became actual loss.

Did we learn the lesson of leverage? Not hardly. Today's systemic leverage is much higher than prior to the credit collapse. The Federal Reserve's balance sheet, for example, currently shows assets of about $4 trillion against capital of about $55 billion. That's leverage of 73:1--far higher than Fannie Mae's at the height of the real estate bubble.

Government and corporate borrowing are once again at epic levels.

Will 2014 be the year where we are presented with another opportunity to learn the lesson of leverage?