The Yale Herald

October 9, 1998

Economics Prof Warns of Impending U.S. Crisis

     By John Yi

John Geanakoplos

For the past several months, global financial woes have continued to grow with no apparent end in sight. Despite these mounting troubles, which have hit Asia and Russia especially hard, the U.S. has remained relatively unscathed. But professor John Geanakoplos, ES '75, expects an American crisis any day now. Geanakoplos, the James Tobin Professor of Economics at Yale, sat down with the Herald to discuss the state of the U.S. economy and its future in light of world events.

Geanakoplos believes that it now seems more likely than ever that the U.S. is headed towards a crisis of its own. Federal Reserve Chairman Alan Greenspan announced on Wed., Oct. 7, "the outlook for the U.S. economy in 1999 has weakened measurably." In addition, J.P. Morgan & Co., the fourth-largest U.S. commercial bank, recently predicted a recession in 1999.

This news came as no surprise at all to Geanakoplos, who teaches advanced intermediate microeconomics. He pointed to the tremendous increase in the availability of easy credit, pointing out that the economy has made much riskier loans. "By continuing to stretch its collateral," Geanakoplos explained, "the [financial] system has created its own possibility of catastrophe."

Geanakoplos continued, "The purpose of a financial system is to let people make promises, i.e., to let them transfer money. In order to make these promises, they must put up collateral. Because collateral is very scarce, as more people make promises, the collateral gets stretched."

For example, Geanakoplos illustrated, if person A borrows money from person B, he may use his house as collateral. Then, person B can borrow money from person C, also using person A's house as collateral. As this chain continues, the collateral essentially becomes "stretched." Clearly, such efficient use of collateral is risky; if person A were to default on his loan, the rest of the chain would be forced to default as well.

Geanakoplos partly blames the Federal Reserve for the current financial situation. "When we were in a booming economy, it was easy to borrow money," he explained. "Since the Fed spends little time monitoring the quality of credit loans, it was extremely easy to get credit cards or second mortgages on homes. Now that we're in a credit crunch, it's more difficult to borrow."

As a result of the credit crunch, as well as the current environment of risk-aversion, the U.S. now seems to be headed towards a recession. This, of course, could have further economic consequences, since, according to Geanakoplos, "There will be a possibility of default if a recession hits." To make matters worse, if the U.S. economy falters, the world's economy will falter as well.

Geanakoplos, however, believes math can help solve the economy's problems. Geanakoplos is Director of the Cowles Foundation, an organization founded by Alfred North Cowles after the famous stock market crash of 1929. The Foundation studies the use of mathematics in the social sciences, particularly economics. "The Cowles Foundation may be the most influential force in the history of mathematical economics," Geanakoplos maintained.

Fortunately, Geanakoplos's mathematical crystal ball tells him a U.S. crisis may be avoidable. "The government should insure transparency," he recommended. "It should force hedge funds to reveal the amount of money they are borrowing." Interestingly, Geanakoplos himself is a partner in a hedge fund that buys mortgaged derivatives. Still, he believes it is essential that the U.S. government begin to bring potentially risky activities to light.

So, what happens if America does end up in a crisis? "Well, after things crash, there are great opportunities," Geanakoplos stated optimistically.