3. Describe the balance sheet effect. Describe the vicious cycle of deleveraging. Why is it necessary for the government to step in to halt a vicious cycle of deleveraging?
The balance sheet effect occurs when asset sales cause declines in asset prices, which then reduce the value of other firms’ net worth as the value of the assets on their balance sheets declines. In the vicious cycle of deleveraging, the balance sheet effect on firms forces their creditors to call in their loan contracts, forcing the firms to sell assets to pay back their loans, leading to further asset sales and price declines. Because the vicious cycle of deleveraging occurs across different firms and no single firm can stop it, it is necessary for the government to step in to stop it.