What is deleveraging?
Given the recent kerfuffle over S&P’s decision to downgrade the U.S. credit rating to outlook negative, it bears remembering how we got here. I think the key word is deleveraging.
In June of 2008, I took a stab at defining the term:
The term deleveraging is one bandied about a lot in the press recently. But, what does it actually mean? De-leveraging is the process by which financial institutions and investors reduce the relative size of their assets to equity ratio. Generally, it means shedding assets in the financial sector, thus reducing credit and slowing the economy.
What happened leading up to the crisis is that the US private sector increased its debt levels tremendously. This was especially true of US households and financial institutions. I took a brief look at the Asset-Based Economy at economic turns back in 2009 and documented the debt increases. It showed, for example, that the debt to GDP levels in the household and financial sectors doubled over the quarter-century leading up to the crisis. Nominal debt levels increased by many times more.
As economists Jean-Louis Arcand, Enrico Berkes, and Ugo Panizza recently documented:
Over the last three decades the US financial sector has grown six times faster than nominal GDP. This column argues that there comes a point when the financial sector has a negative effect on growth – that is, when credit to the private sector exceeds 110% of GDP. It shows that, of the advanced countries currently suffering in the fallout of the global crisis were all above this threshold.
I would like to see the same approach taken to analysing household sector debt as well. I suspect the analysis is similar. After all financial sector leverage is a by-product of debt taken on by the private sector – either businesses or households.
Here’s the thing: large increases in debt in the private sector are the product of low savings. That is to say, debt increases because agents are engaged in deficit spending, with the debt making up the difference between income and outlays. As you know from Economics 101 on government budget deficits, the deficits in one sector are exactly offset by surpluses in the other sectors of an economy. That means that, in an economy in which the financial and household sectors have a deficit, you need to see a net surplus of equivalent amount in the non-financial business, trade, and government sectors.
Where does that lead us today? In a world in which the financial and household sectors are highly indebted and need to deleverage to prevent another crisis, you are going to see net surpluses in those sectors. That necessarily means you need to see a net deficit of equivalent amount in the non-financial business, trade, and government sectors. That’s how the numbers work. You can’t have both private sector and public sector deleveraging at the same time without an equivalent change in the current account. What we have seen thus far shows the government sector going into a huge deficit as a result.
When I look at this from a macro perspective:
I see the increase in public sector debt in a balance sheet recession as a socialization of losses. If you look at any economy that has suffered steep declines in GDP, what we have seen are a reduction in tax revenue, an increase in government spending and bailouts. This is true in Ireland, the UK, and the U.S. in particular. In effect, what is occurring is a transfer of the risk borne by particular agents in the private sector onto the public writ-large. The magnitude of this risk transfer via annual double digit increases in debt-to-GDP is breathtaking.
Finally, these debt levels are unsustainable for the world as a whole. Japan has been able to run up public sector debt to 200% of GDP because it alone was in a balance sheet recession and its private sector was willing to fund this debt. But, things are vastly different now. Sovereign defaults are likely. The debt crisis in Greece is a preview of what is to come. Those debtors which attempt to most increase the risk transfer onto the public will soon find debt revulsion a very real problem. And what will invariably happen is that a systemic crisis will ensue…
I do not believe this private sector balance sheet recession can be successfully tackled via collective public sector deficit spending balanced by a private sector deleveraging. The sovereign debt crisis in Greece tells you that. More likely, the western world’s collective public sectors will attempt to pull this off. But, at some point debt revulsion will force a public sector deleveraging as well.
And unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken. The question still up for debate is regarding systemic risk, contagion, and economic nationalism because when the first large sovereign default occurs, that’s when systemic risk will re-emerge globally.
In countries that issue debt in their own currency, the crisis will be ‘fake’, meaning that the overwhelming majority of questions from those who don’t understand how money works will revolve around solvency. Government creates the currency, they can always manufacture more to fulfil IOUs in that currency if they so choose. The real question should go to malinvestment, currency depreciation and inflation.
In countries that do not issue debt in their own currency, this crisis will be real. As we have seen with the euro zone, being a currency user means involuntary default is a real medium-term issue.
P.S. – I am not concerned about an involuntary default by the US government for solvency reasons. I am concerned about a voluntary default by the US government for political reasons.