A Hard Slog in the Foothills of Debt

“Deleveraging” is an ugly word for a nasty journey: that towards lowering excessive debt after a credit bubble. What makes the effort particularly difficult now is that it affects the US and other large economies. This is a global, not just a local, event.


In January, the McKinsey Global Institute published an updated version of its invaluable research on deleveraging.* It is a sobering document: it shows that deleveraging has a long way to go; happily, it also shows that the US economy is the most advanced in deleveraging.

One cannot get out of debt by taking on more debt. How often have you read such remarks? It is a cliché. As the McKinsey Global Institute study points out, it is also false. Sweden and Finland, both hit by big crises in the early 1990s, are good examples of why this is so.

The benign story unfolds like this: a big increase in leverage ends in a huge financial crisis; the government promptly restructures the financial system; excessively indebted private borrowers reduce their obligations by slashing spending; central banks cut interest rates; the resulting collapse in activity and profits pushes the government into huge fiscal deficits, which also support the economy; finally, the economy recovers, helped by exports, and the government begins its fiscal retrenchment.

Thus the temporary rise in fiscal deficits helps protect the economy from the forced private retrenchment. The alternative would be a depression, in which mass bankruptcy, not repayment, lowers debt. Unfortunately, the smooth adjustment path takes time. It also depends on the government’s creditworthiness, which has to be far better than that of the private sector. This has been true for the US and UK, but not Spain, which is being coerced into savage retrenchment.

The danger is that the private sector never recovers fully, as seems to have happened in Japan. The McKinsey report lays out what must happen if that danger is to be avoided. The list includes: stability in the banking system; credible plans for fiscal sustainability; structural reform; rising investment and exports; and stability in the housing market and rebounding construction.

The amount of leverage the economy can support depends on who has borrowed and lent, on the value of the collateral and, not least, on economic activity. The surest ways to inflict an unnecessarily destructive reduction in leverage is to allow the economy to collapse. That is why aggressive monetary policy and large temporary fiscal deficits matter. If the public sector does not sustain spending as the private sector cuts back, the latter will go too far, causing unnecessarily deep damage to the economy.

Where then is the deleveraging now? In the case of the US, leverage declined by 16 percentage points, relative to gross domestic product , between 2008 and the second quarter of 2011. Over the same period, leverage rose in the UK and Spain. This is partly because the US has been far more successful than the UK and Spain in sustaining output. The US has also seen successful deleveraging in the financial and non-financial corporate sectors. In the UK and Spain, however, the financial sector has not deleveraged. Above all, the US has cut household leverage more than in the UK and Spain. It has even seen an absolute fall in household debt, largely due to default. Household debt has even returned to its long-run trend, though households are only a third of the way towards matching the Swedish deleveraging of the 1990s.

In all, the post-crisis US looks to be in better shape than these other two economies. Aggregate leverage (at 279 percent of GDP in the second quarter of 2011) is far lower than in the UK (507 percent) and Spain (363 percent). The ability of the US government to borrow remains strong. The UK government’s borrowing costs also remain low. The enormous balance sheets of its financial sector, at 219 percent of GDP, explain much of the high UK leverage. But the UK government is retrenching, while deleveraging in the private sector is very slow. The cost of government borrowing is far higher in Spain than the US and UK, while private sector deleveraging has remained very limited, until now.

All these economies confront risks on their journey towards exit from the crisis. The US, for example, lacks a plan for fiscal sustainability and is too big to expect more than a modest boost from exports. Investment, including construction, must drive its recovery. In the absence of a jump in private investment that does not depend on rising leverage, it may prove difficult to eliminate the fiscal deficit. Again, surges in corporate investment and net exports are essential if the UK economy is to recover and the fiscal deficit is to be eliminated, as the government wants. The UK faces the additional threat of a meltdown in the euro zone, which could inflict serious damage on its financial sector. In the case of Spain, a rapid shift in net exports must play the dominant role in the recovery, not least because Spain’s non-financial corporate sector is already highly leveraged, with debt at 134 percent of GDP in the second quarter of 2011, against 109 per cent inthe UK and 72 percent in the US.

In all, it is going to take quite a long time to escape the aftermath of the biggest financial crisis since the 1930s. The good news is that a depression was prevented. Further good news is that private sector deleveraging is progressing, especially in the US. As asset prices stabilise and the economies adjust, it should be possible to withdraw the exceptional monetary and fiscal support. The bad news is that this is likely to take longer than many expect. Premature withdrawal of monetary and fiscal support could push afflicted economies back into recession, with devastating effects on confidence. In the long run, moreover, big shifts in the external accounts will be necessary if a new round of irresponsible private borrowing or a continuation of huge fiscal deficits is to be avoided.

The road to deleveraging will be long and hard. It is essential to map out the road, including towards post-crisis fiscal consolidation. It is as important to realise that the story is still at its beginning, even in the US.