How the Economic Machine Works - Part 4

Deleveraging Explained

Key Concepts: Deleveraging, Recession, Austerity, Debt Restructuring, Deflation, Depression, Debt Burden, Central Bank Printing Money.

What is Deleveraging?

Deleveraging is a period where people reduce spending, leading to falling incomes, disappearing credit, dropping asset prices, squeezed banks, stock market crashes, and rising social tensions. This creates a self-reinforcing negative cycle. Borrowers are squeezed as incomes fall and debt repayments rise, making them less creditworthy. They are forced to sell assets to cover the shortfall, flooding the market and causing asset prices to collapse. This further reduces the value of collateral, exacerbating the problem. The result is less spending, less income, less wealth, less credit, and less borrowing.

Deleveraging vs. Recession

While similar to a recession, a deleveraging differs in a crucial aspect: interest rate cuts are ineffective. In a recession, lowering interest rates stimulates borrowing and economic activity. However, in a deleveraging, interest rates are already low (often near 0%) and cannot be lowered further to provide stimulus. The deleveraging of the 1930s and 2008 in the United States saw interest rates hit 0%. The core issue in a deleveraging is that borrowers' debt burdens are simply too large to be relieved by lower interest rates. Lenders recognize that debts are unlikely to be fully repaid, leading to a credit freeze.

Four Ways to Reduce Debt Burdens in a Deleveraging

The problem in a deleveraging is that debt burdens are too high and must be reduced. There are four primary ways this can happen, all of which have occurred in every deleveraging in modern history:

1. Cutting Spending (Austerity): People, businesses, and governments reduce spending to pay down debt.
2. Debt Reduction (Defaults and Restructurings): Debts are reduced through defaults and restructurings.
3. Wealth Redistribution: Wealth is redistributed from the wealthy to the less wealthy.
4. Central Bank Printing Money: The central bank prints new money.

Cutting Spending (Austerity) and its Consequences

Typically, spending cuts are the first response. Borrowers stop taking on new debt and focus on paying down existing debt. This is often referred to as austerity. However, cutting spending leads to falling incomes because "one man's spending is another man's income." Incomes fall faster than debts are repaid, causing the debt burden to worsen. This cut in spending is deflationary and painful, forcing businesses to cut costs, leading to job losses and higher unemployment.

Debt Reduction (Defaults and Restructurings) and its Consequences

Many borrowers become unable to repay their loans. A borrower's debt is a lender's asset. When borrowers default, lenders (like banks) face the risk of not being able to repay their own obligations, leading to bank runs. This can result in widespread defaults by people, businesses, and banks, leading to a severe economic contraction known as a depression. A key aspect of a depression is the realization that much of what was thought to be wealth is actually not there.

Example: A bar tab represents a promise to repay. The bartender considers this promise an asset. However, if the customer defaults on the tab, the asset disappears.

To avoid complete loss, lenders may agree to debt restructuring. This involves lenders accepting less money, longer repayment periods, or lower interest rates than originally agreed. While debt restructuring reduces debt, it also causes income and asset values to disappear faster, so the debt burden continues to get worse. Like cutting spending, debt reduction is also painful and deflationary.

Conclusion

Deleveraging is a complex and painful process characterized by a self-reinforcing cycle of debt reduction, falling incomes, and asset deflation. While there are four primary ways to address the problem of high debt burdens, the initial steps of cutting spending and debt reduction are often deflationary and can exacerbate the situation.