Leveraged

Credit booms distort economies, and economic slowdowns inevitably ensue.

The current regulation of the financial system is too focused on minimizing the risk of banks getting into trouble. The biggest impact of financial crises lies in the accompanying dramatic drop in consumer spending and loss of confidence in the wider economy. Sharing the risks of the fallout when the economy turns would be a better approach.

One crucial way to tackle this would be the use of “state-contingent contracting” (SCCs) in which, during a downturn, contracts automatically reduce the amount a borrower needs to pay back. Examples of SCCs already in use include student loans in which the payback is contingent on the borrower’s earnings, as well as loans to countries in which the repayment depends on GDP growth. A crucial SCC policy would be a “shared responsibility mortgage” (SRM), whereby homeowner repayments would reduce when house prices fell.

Credit booms distort a country’s economy, as more labor, business capital and private credit go toward real estate, construction and domestic consumption, and imports increase. Meanwhile, rising...