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Abstract

Contrary to the beliefs of most macroeconomists, the financial sector in the United States has grown too large in the last few decades as a consequence of financial innovation that has encouraged the use of too much “leverage” (financing with debt) by financial institutions (as well as by consumers and other borrowers). In Part II, I connect the dots between excessive leverage, risk, and financial market volatility. In Part III, I explore the role that the “shadow-banking sector” has had in driving leverage. In Part IV, I explain why leverage at the level of financial institutions matters for the macroeconomy. In Part V, I argue that excessive leverage causes instability in financial markets and in the economy as a whole. Finally, I conclude by arguing that these problems in the financial sector will not be selfcorrecting because leverage has helped to drive up profits and incomes over time in the financial sector.