Deleveraging? What Deleveraging?

by: Herve van Caloen


Deleveraging is painful, think 1930s.

We avoided a depression by refusing to deleverage the global economy.

The hard adjustments are still ahead.

When debt burdens become too large, deleveraging must happen. Such deleveraging is painful as it implies austerity and hardship. That's why it doesn't happen often.

Debt binges tend to be followed by long, painful years of adjustments and generations that have to endure these conditions don't forget easily. They are forever wary of excessive debt-causing asset bubbles that precede financial crises. Think about the generation that lived through the Depression in America or the "lost generation" in Japan.

However, collective memories fade with each generation. New bubbles do appear after a while - it is human nature - the most recent example being the housing bubble and its implosion in 2008. But that time the Fed reacted swiftly, determined to avoid the pain of past deleveragings.

It worked. There is no arguing that the Fed has been able to avoid a depression. Five years into the recovery, stock prices are at all time highs and unemployment is under 7%. This would suggest that we have finally figured out how to manage deleveragings properly without creating tremendous hardship.

But, have we really? A quick look at some numbers tells a very different story. In fact, all we have done is replace the usual deleveraging with a doubling down. We avoided a major recession - or even a depression - by releveraging the entire world economy.

When looking at the economies of the US, China or Japan, one doesn't see any deleveraging. Quite the contrary. The financial crisis of 2008 produced a further expansion of the global bubble economy model based on unrestrained debt. Even Europe has not deleveraged.

MarketWatch published an article on June 19, 2014 claiming that "Americans are getting into debt to afford food, gas." This is hardly the behavior of consumers trying to clean up their balance sheets. The author, Peter Atwater, explains that for "have-nots" "the continued absence of wage growth has resulted in an unprecedented boom of non-discretionary credit." These "needs, not wants" include education and cars; the latter are now often bought with seven-year leases. For average Americans, the non-core inflation of food and energy does not leave much cash for other essentials.

Consumer loans in the US total $11.5 trillion today, up from $5 trillion in the year 2000*. The number did come down briefly from its 2008 peak the first year after the financial crash, but it is back to 2007 levels and going up rapidly. "Consumer debt hasn't jumped this much since before the recession," according Reuters.**


While consumer debt is near the all-time highs of 2008, government debt barreled right through its previous levels and continues relentlessly upward. This is so well-publicized that we barely even talk about it anymore. From $5.7 trillion in the year 2000, it is rapidly approaching $18 trillion.

The corporate sector is awash with cash, although domestic credit to the private sector is still hovering around 130%, in line with the years prior to the financial crisis. The last number published by The World Bank is 127% for the year 2012. Considering corporations' strong balance sheets and the fact that this kind of debt could be considered "productive," one would actually hope to see more of it and less of the others. As long as businesses can borrow cheaply to finance high returning projects, the overall economy benefits.

Is that what the Chinese corporations had in mind when they started their debt binge 5 years ago? "Cash flows and leverage at Chinese companies are the worst among global peers, having deteriorated from being the best in 2009."*** China's corporate bond market has just overtaken the United States as the world's biggest. Corporate borrowers owed $14.2 trillion in China vs. "only" $13.1 trillion in the US ****. One can only hope such a brisk change in China's corporations' attitude was triggered by a massive increase of new opportunities. However, the slowdown in GDP growth since 2009 suggests there is something else at play.

Good Deleveraging vs. Bad Deleveraging.

In a very interesting note published in February 2012, Ray Dalio, the famed investor and founder of Bridgewater Associates, argues that a good deleveraging process depends on the right mix of 4 things: debt reduction, austerity, transferring wealth from the haves to the have-nots and debt monetization. If so, the management of the aftermath of the 2008 financial meltdown cannot be labeled a success.

Of these four policies, only one was forcefully and universally implemented: money printing. As far as the other three policies, debt reduction was replaced by more debt, austerity was only forced upon a few peripheral countries of Euroland, and the transfer of wealth happened in reverse - from the have-nots to the haves thanks to the fabulous "wealth effect" engineered by the Fed.

Come to think of it, the wealth effect not only made the rich richer without creating more revenues, it also allowed for the re-leveraging of the economy. By artificially boosting the asset side of one's balance sheet, a clear incentive is given to increase the liability side too.

A global deleveraging is still ahead of us. Let's hope we really figured out how to manage it.

Source: FRBNY Consumer Credit Panel/Equifax

* Reuters article posted 02/18/2014

** and ****South China Morning Post Tuesday, 17 June, 2014 referring to a Standard & Poor's study. Note that The World Bank may have different numbers, depending on whether one includes trade credits, account receivables, etc.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.