At themicro-economic level,deleveraging refers to the reduction of theleverage ratio, or the percentage ofdebt in thebalance sheet of a single economic entity, such as a household or a firm. It is the opposite ofleveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses.
At themacro-economic level,deleveraging of an economy refers to the simultaneous reduction of debt levels in multiple sectors, includingprivate sectors and thegovernment sector. It is usually measured as a decline of the total debt toGDP ratio in thenational accounts. The deleveraging of an economy following afinancial crisis has significant macro-economic consequences and is often associated with severerecessions.
Whileleverage allows a borrower to acquireassets and multiply gains in good times, it also leads to multiple losses in bad times. During a market downturn when the value of assets and income plummets, a highly leveraged borrower faces heavy losses due to his or her obligation to the service of high levels of debt. If the value of assets falls below the value of debt, the borrower then has a high risk todefault. Deleveraging reduces the total amplification of market volatility on the borrower'sbalance sheet. It means giving up potential gains in good times, in exchange for lower risk of heavy loss and nastydefault in bad times.
However, precaution is not the most common reason for deleveraging. Deleveraging usually happens after a market downturn and hence is driven by the need to cover loss, which can deplete capital, build a less risky profile, or is required by nervous lenders to prevent default. In the last case, lenders lower the leverage offered by asking for a higher level ofcollateral anddown payment. It is estimated that from2006 to 2008, the average down payment required for a home buyer in the US increased from 5% to 25%, a decrease of leverage from 20 to 4.[1]
To deleverage, one needs to raise cash to pay debt, either from raising capital or selling assets or both. A bank, for example, can cut expenditure, sellliquid assets, absorb off-balance-sheetstructured investment vehicles and conduits, or allow its illiquid assets to run off atmaturity, which, however, can take a long time.
Deleveraging is frustrating and painful forprivate sector entities in distress: selling assets at a discount can itself lead to heavy losses. In addition, dysfunctionalsecurity andcredit markets make it difficult to raise capital from public market. Privatecapital market is often no easier:equity holders usually have already incurred heavy losses themselves, bank/firmshare prices have fallen substantially and are expected to fall further, and the market expects the crisis to last for a considerable length of time. These factors can all contribute to hindering the sources of private capital and the effort of deleveraging.
Deleveraging of an economy refers to the simultaneous reduction of leverage level in multipleprivate andpublic sectors, lowering the total debt tonominal GDP ratio of the economy. Almost every majorfinancial crisis in modern history has been followed by a significant period of deleveraging, which lasts six to seven years on average. Moreover, the process of deleveraging usually begins a few years after the start of the financial crisis.[2]
As in January 2012, four years after the start of theGreat Recession, many mature economies andemerging economies in the world had just begun to go through a major period of deleveraging.[3] This is mainly because the continuing rising ofgovernment debt, due to theGreat Recession, has been offsetting the deleveraging in the private sectors in many countries.[4]
TheMcKinsey Global Institute defines a significant episode of deleveraging in an economy as one in which the ratio of total debt to GDP declines for at least three consecutive years and falls by 10 percent or more.[2] According to this definition, there have been 45 such episodes of deleveraging since 1930, including:
Based on this identification of deleveraging andCarmen Reinhart andKenneth Rogoff’s definition for major episodes offinancial crisis,[5] it is found that almost every major financial crisis during the period of study has been followed by a period of deleveraging.[2] After the 2008 financial crisis, economists expected deleveraging to occur globally. Instead the total debt in all nations combined increased by $57 trillion from 2007 to 2015 and government debt increased by $25 trillion. According to the McKinsey Global Institute, from 2007 to 2015, five developing nations and zero advanced ones reduced theirdebt-to-GDP ratio and 14 countries increased it by 50 percent or more. As of 2015, the ratio of debt to gross domestic product globally has increased by 17 percent after the crisis.[6]
According to aMcKinsey Global Institute report, there are four archetypes of deleveraging processes:[2]
Massive deleveraging in corporate and financial sectors can have serious macro-economic consequences, such as triggeringFisheriandebt deflation and slowingGDP growth.[7][8]
In the financial sector, the need to deleverage causesfinancial intermediaries to shed assets and stop lending, resulting in acredit crunch and tighterborrowing constraint for business, especially the small to medium-sized enterprises. Many times, this process is accompanied by aflight to quality by the lenders and investors as they seek less risky investment. However, many otherwise sound firms could go out of business due to the denied access to credit necessary for operation. Moreover, firms in distress are forced to sell assets quickly to raise cash, causingasset prices to collapse. The pressure ofdeflation increases the real burden of debt and spreads loss further in the economy.
In addition to causing deflation pressure, firms and households deleveraging theirbalance sheet often increase net savings by cutting expenditures sharply. Households lower consumption, and firms fire employees and halt investment in new projects, causing unemployment rate to rise and even lower demand of assets. Empirically, consumption and GDP often contracts during the first several years of deleveraging and then recovers,[2] which in some cases cause a fall in total savings in the economy, despite the individuals' higherpropensity to save. This is known as theparadox of thrift.
According to the theory ofleverage cycle ofJohn Geanakoplos and originally byHyman Minsky, in the absence of intervention,leverage becomes too high inboom times and too low inbust times. As a result, asset prices become too high in boom times and too low in bad times, rather than correctly reflecting thefundamental value of assets.[1] This recurring leveraging-deleveraging cycle is one of the most important amplifying mechanism contributing to thecredit cycles andbusiness cycles. Deleveraging is responsible for the continuing fall in the prices of both physical capital and financial assets after the initial market downturn. It is part of the process that leads the economy torecession and the bottom of theleverage cycle.
Therefore, some economists, includingJohn Geanakoplos, strongly argue that theFederal Reserve should monitor and regulate the system-wide leverage level in the economy, limiting leverage in good times and encouraging higher levels of leverage in bad times, by extending lending facilities.[1][9] Moreover, it is more important to restrict leverage in ebullient times to prevent the crash from happening in the first place.[1]
In addition, in the face of massive private sector deleveraging,monetary policy has limited effect, because the economy is likely to have been pushed up against the zero lower bound, wherereal interest rate is negative butnominal interest rate cannot fall below zero. Some economists, such asPaul Krugman, have argued that in this case,fiscal policy should step in anddeficit-financed government spending can, at least in principle, help avoid a sharp rise inunemployment and the pressure ofdeflation, therefore facilitating the process of private sector deleveraging and reducing the overall damage to the economy.[10] Note that this comes at the expense of higher government debt, which will compromise the overall deleveraging of the economy. This view is in contrast with some other economists, who argue that a problem created by excessive debt cannot be ultimately solved by running up more debt, because unsustainably highgovernment budget deficit could seriously harm the stability and long-run prospect of the economy.
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