Debt Deleveraging: Where We’re At

The problem that the world finds itself in is widely acknowledged to be a problem of debt and insolvency. Until now, most of the solutions attempted have been to fix problems of liquidity arising from the debt problem without attacking the underlying debt problem. Indeed as we write, we watch the ongoing futile European attempt to fix over-indebtedness and insolvency by exerting ever effort to prevent capital loss as a means of deleveraging.

McKinsey & Company published a report this week titled “Working out of debt“. Their report acknowledges that deleveraging is necessary, shows where we are in the debt deleveraging cycle and discusses what is necessary for the world to try and grow its way out of debt.

What follows is a presentation of their key points with our comments. The reader is referred to our many other posts, on debt, particularly our 4-part series on money starting with “Understanding Money: Part 1 – Introduction” and our post “Has the Thief Been Caught?” in which we posit that excessive debt reduces future growth, an effect that is already well underway.

The importance that the authors assign to deleveraging caused by excessive debt is that it acts as a drag on growth or GDP which only rebounds in the later stages of deleveraging.They also note that:

Overall, the deleveraging process has only just begun. During the past two and a half years, the ratio of debt to GDP, driven by rising government debt, has actually grown in the aggregate in the world’s ten largest developed economies …. Private-sector debt has fallen, … [as] households and corporations typically lead the deleveraging process; governments begin to reduce their debts later … into recovery.

They note that over 2/3 of the deleveraging of household debt has come from default. This begs the question as to whether we should expect anything different for sovereign debt? They estimate that that US households could be up to halfway through the deleveraging process, with one to two years of further debt reduction ahead. They support their point using the following graph.

We have added vertical lines at the major points the historical data line touches or crosses the trend line. We have drawn a horizontal line representing a possible overshoot of the trend line by the deleveraging process. More properly, all measurements and projected lines should be measured at the perpendicular to the trend and parallel to it.

Exhibit 1 (see the report cited above)
Although the debt ratio of US households remains high, they may be halfway through the deleveraging process.

The graph and its trend-line invite some very interesting observations.

  1. The trend line is upward sloping. One might expect a relatively constant ratio. But this trend says as people’s disposable income has risen, their appetite for debt has increased at a faster rate roughly doubling in 50 years. This of course is unsustainable so at some point the trend should level out or become parabolic.
  2. Debt to income recently peaked at about 130%. We suggest this is a measure of the maximum amount of debt relative to disposable income that households can currently absorb before a crisis-induced correction occurs. Since these are national aggregates, interest rates, the general economic climate, the unemployment numbers, the state of housing, and many other factors would likely affect the value of this maximum ratio. However the idea that in any economy there is a maximum is an attractive hypothesis.
  3. The earlier peak around 1965 marked a roughly 15-year period of rates above trend followed by roughly 15 years of rates below trend. Further, the depth of the correction below trend for that cycle was roughly the height of the peak. If the current cycle behaves like the past cycle and the authors’ projection of reversion to trend is accurate giving another 15-year period above trend, we might expect a 15-year period where the correction takes us below trend by an amount similar to the peak. Certainly when natural systems revert to trend it is common to overshoot. Whereas the authors suggest deleveraging will occur another 2-3 years in the US to return to trend, it could take another 5-7 years to reach the depth  of an overshoot. Based on this reasoning, our forecast is another 7-10 years of deleveraging!

The authors do a comparison of the progress of household deleveraging in the US, the UK, and Spain against the deleveraging cycle that Sweden went through in the 1990s. The graphical comparison the authors make in the report is

Exhibit 2 (see the report cited above)
In the United States, household deleveraging may have only a few more years to go, while in Spain and the United Kingdom it has just begun.

If US deleveraging follows a similar trajectory to Sweden’s, then the US still has roughly 7-9 years of deleveraging left. Another observation is that the rates of deleveraging for the three economies shown are less than Sweden’s suggesting the process may take longer than Sweden’s.

In this graph, the start of the deleveraging cycle for each country has been positioned at the 0 point or start of the shaded area representing the Swedish deleveraging cycle. We would infer from this graph that countries currently going through this cycle – most of the developed economies – will take a lot longer than the Swedish experience.

Finland, Sweden, and South Korea went through credit-induced financial crises in the 1990s caused by deregulation (or lax regulation) in the banking sector leading to a credit boom. This in turn created real-estate and other asset bubbles that collapsed leading to deep recessions and debt deleveraging. As the authors note, in all three countries, growth was essential for completing a five- to seven-year-long deleveraging process. We will discuss below why this is unlikely to happen in the current global crisis.

Finally, the authors suggest five essentials  for a country to grow its way out of the debt collapse:

  1. a stable banking system,
  2. structural reforms that support growth,
  3. a surge in exports,
  4. rising private investment, and
  5. a stabilized housing market.

Commentary

Our first observation is that the three example crises occurred as isolated rather than global events in an otherwise healthy global economy.  This is not the state of affairs today. Currently we are not faced with a number of individual crises but a global crisis that involves all the world’s major economies. Reviewing the five points for growth:

  1. The banking sector in the US, China, Spain, Ireland, Austria and probably most of Europe and Japan carry large portfolios of non-performing loans on their books. Surviving on an intravenous feed of liquidity from central banks, Western banks are far from stable. In the addendum below, Ambrose Evans-Pritchard argues that US banks are in much better shape than EU banks.
  2. The trend in the US and the EU has been to increasing regulation in and of national economies. The threat of trade wars is rising as currency wars have begun. This trend is towards structural changes that deter growth.
  3. We are well into a global currency war with competitive devaluations having taken place in Switzerland, Japan, Brazil and other countries while monetary policy in the US and the EU have achieved the same effect as direct currency intervention. As the global economy moves towards recession, a trend that the IMF and World Bank regularly document, the need for exports will accelerate the devaluation of currencies globally. When every country needs and tries to increase their balance of payments through exports over imports, no country can achieve it.
  4. The strategy of fighting the crisis by avoiding deleveraging through credit contraction and substituting liquidity expansion programs instead, directs increasingly more and scarcer capital from the private sector towards the public sector. The debt deleveraging process with attendant deflation is about capital destruction at a time when competition for capital and demand for it is increasing.
  5. The failure of financial institutions to clean up their real estate portfolios and take a one-time hit on non- and under-performing assets means the real estate sector cannot begin to stabilize. Certainly the US is farther along than EU countries and China towards a resolution of this part of the problem.

In summary, non of the five requirements for a growth-led solution to debt deleveraging are in place and many are a long way from being in place based on current monetary and fiscal policies.

As a final comment, the authors state that US households could be 1-2 years from the end of their deleveraging process. Our analysis of the two graphs they present lead us to conclude that the deleveraging remaining will last 7-10 years, not 1-2. Indeed, with the conditions for growth out of debt nowhere near optimal, and a global economy that is faltering, this process could drag out even longer.

Addendum

Ambrose Evans-Pritchard references this report as he expands on the severity of the European and British situation compared to the US (America overcomes the debt crisis as Britain sinks deeper into the swamp). He gives a graph comparing the 10 largest developed economies and their states of deleveraging.

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