Deleveraging a process, not an event
It may be about as fun as having a tooth pulled, but cutting very high levels of debt in an economy is more of a process than a short, sharp event.
That means that for economies like that of the United States, which has private debt equal to 268 percent of gross domestic product, the outlook is for a very long period of subdued growth and one in which there is no assurance that the tools of economic management, traditional or not, will be effective.
The Federal Reserve released its Flow of Funds report last week, detailing the state of the country’s various balance sheets and the news was good, in its own way, but not encouraging.
Household net worth contracted in the second quarter, mostly due to falls in the value of financial assets, falling by about $1.5 trillion, or about 3 percent. Net worth is down a substantial 12.3 trillion, or nearly 20 percent, from its peaks in 2007.
Deleveraging is happening, at least in the private sector, with the ratio of debt to GDP down by a very chunky 10.3 percent, a fall that is already half again as large as the very painful running down of debt in the 1970s. Even so, there are good reasons to think that we’ve not yet paid off or defaulted on enough debt to be on solid ground to leverage up again.
“Speculators have to be encouraged to take on a level of debt whose servicing consumes a dangerously high proportion of their income, in the belief that rising asset prices will let them repay that debt with a profit in the near future,” Steve Keen, an economist at the University of Western Sydney wrote.
“With the debt to GDP levels for all non-government sectors of the American economy at unprecedented levels, the prospect that any sector can be enticed to take on yet more debt is remote. Deleveraging is America’s future.”
Debt is certainly being extinguished: households slashed debt at a 2.3 percent rate in the second quarter, with financial sector debt falling at a more than 7 percent rate. Of course, as the rest of the economy was cutting debt the government was adding it even faster, an additional $2 trillion in the quarter as government debt increased at a 24.4 percent annual rate.
DEFAULT IS DE-LEVERAGING
Before we celebrate the American household sector’s ability to pay back what it has borrowed, it is probably best to take a closer look at how that was accomplished. Mark Whitehouse of the Wall Street Journal cleverly compared the $610 billion decline in household debt over the two years to June to bank writedowns of mortgages and consumer debt during that period, finding that the vast majority, 99.92 percent, of the decline was in the form of defaults.
From one perspective this is well and good. Nothing speeds up the repair of a household’s balance sheet like defaulting and scrubbing the board clean, especially if the assets against which the debt is secured are not likely to quickly rebound in value, as is the case with housing.
Think, though, about what happens to the household when it defaults. It will find that its access to credit is seriously impaired. Buying a house, borrowing to buy a car or start a business all will be much more difficult, if possible at all, for a couple of years.
Many in the United States came to view their assets and their access to credit as a safety net during the past decade. They didn’t save because they reasoned that if they lost their job or fell ill they could borrow against their house, sell shares or even use a credit card to tide them over.
People who have defaulted will save, hard, to build up money against future shocks and to lay the groundwork for future asset purchases. This is great news seen over a decade but means there could be some very hard sledding this winter and next year as deleveraging continues, in all its forms, and as the savings rate moves higher.
In the meantime, the assets households are defaulting on, notably houses but boats, cars and anything else you care to name, will increasingly find their way on to the market, further depressing prices and encouraging yet more defaults.
The Federal Reserve may choose to try to arrest this process with another, perhaps bigger round of quantitative easing, hoping to touch off more speculation to support asset prices. It may, and it might or might not work, but it would be a move that would come at a high price, both politically and in terms of credibility.