Cecchetti & Schoenholtz
It's the leverage, stupid!: In the 30 months following the 2000 stock market peak, the S&P 500 fell by about 45%. Yet the U.S. recession that followed was brief and shallow. In the 21 months following the 2007 stock market peak, the equity market fell by a comparable 52%. This time was different: the recession that began in December 2007 was the deepest and longest since the 1930s.
The contrast between these two episodes of bursting asset price bubbles ought to make you wonder. When should we really worry about asset price bubbles? In fact, the biggest concern is not bubbles per se; it is leverage. And, surprisingly, there remain serious holes in our knowledge about who is leveraged and who is not. ...
All of this leads us to draw two simple conclusions. First, investors and regulators need to be on the lookout for leverage; that’s the biggest villain. In the United States and many other countries, mortgage borrowing has been at the heart of financial instability, and it may be so again in the future. But we should not be lulled into a sense of security just because banks’ real estate exposure has declined. If leverage starts rising in real estate or elsewhere – on or off balance sheet – then we should be paying attention.