deleveraging
   HOME

TheInfoList



OR:

At the
micro-economic Microeconomics is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics fo ...
level, deleveraging refers to the reduction of the
leverage ratio In finance, leverage (or gearing in the United Kingdom and Australia) is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever i ...
, or the percentage of
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
in the
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
of a single economic entity, such as a household or a firm. It is the opposite of leveraging, which is the practice of borrowing money to acquire assets and multiply gains and losses. At the macro-economic level, deleveraging of an economy refers to the simultaneous reduction of debt levels in multiple sectors, including
private sectors The private sector is the part of the economy, sometimes referred to as the citizen sector, which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government. Employment The ...
and the government sector. It is usually measured as a decline of the total debt to
GDP Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjective nature this measure is ofte ...
ratio in the
national accounts National accounts or national account systems (NAS) are the implementation of complete and consistent accounting techniques for measuring the economic activity of a nation. These include detailed underlying measures that rely on double-entry ...
. The deleveraging of an economy following a
financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
has significant macro-economic consequences and is often associated with severe
recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
s.


In microeconomics

While
leverage Leverage or leveraged may refer to: *Leverage (mechanics), mechanical advantage achieved by using a lever * ''Leverage'' (album), a 2012 album by Lyriel *Leverage (dance), a type of dance connection *Leverage (finance), using given resources to ...
allows a borrower to acquire
assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can ...
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 to default. Deleveraging reduces the total amplification of market volatility on the borrower's
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
. It means giving up potential gains in good times, in exchange for lower risk of heavy loss and nasty default 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 of
collateral Collateral may refer to: Business and finance * Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan * Marketing collateral, in marketing and sales Arts, entertainment, and media * ''Collate ...
and
down payment Down payment (also called a deposit in British English), is an initial up-front partial payment for the purchase of expensive items/services such as a car or a house. It is usually paid in cash or equivalent at the time of finalizing the transactio ...
. It is estimated that from 2006 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.
John Geanakoplos, ''The Leverage Cycle'', Cowles Foundation, July 2009.
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, sell
liquid assets In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
, absorb off-balance-sheet
structured investment vehicle A structured investment vehicle (SIV) is a non-bank financial institution established to earn a credit spread between the longer-term assets held in its portfolio and the shorter-term liabilities it issues. They are simple credit spread lenders, ...
s and conduits, or allow its illiquid assets to run off at maturity, which, however, can take a long time. Deleveraging is frustrating and painful for
private sector The private sector is the part of the economy, sometimes referred to as the citizen sector, which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government. Employment The ...
entities in distress: selling assets at a discount can itself lead to heavy losses. In addition, dysfunctional
security" \n\n\nsecurity.txt is a proposed standard for websites' security information that is meant to allow security researchers to easily report security vulnerabilities. The standard prescribes a text file called \"security.txt\" in the well known locat ...
and
credit market The bond market (also debt market or credit market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the secondary market. This is usually in the form of bonds, ...
s make it difficult to raise capital from public market. Private capital market is often no easier:
equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...
holders usually have already incurred heavy losses themselves, bank/firm share prices have fallen substantially and are expected to fall further, and the market expects the crisis to last long. These factors can all contribute to hindering the sources of private capital and the effort of deleveraging.


In macroeconomics

Deleveraging of an economy refers to the simultaneous reduction of leverage level in multiple
private Private or privates may refer to: Music * " In Private", by Dusty Springfield from the 1990 album ''Reputation'' * Private (band), a Denmark-based band * "Private" (Ryōko Hirosue song), from the 1999 album ''Private'', written and also recorde ...
and
public sector The public sector, also called the state sector, is the part of the economy composed of both public services and public enterprises. Public sectors include the public goods and governmental services such as the military, law enforcement, inf ...
s, lowering the total debt to
nominal GDP Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
ratio of the economy. Almost every major
financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
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. As in January 2012, four years after the start of the 2008-09 global financial crisis, many mature economies and
emerging economies An emerging market (or an emerging country or an emerging economy) is a market that has some characteristics of a developed market, but does not fully meet its standards. This includes markets that may become developed markets in the future or were ...
in the world had just begun to go through a major period of deleveraging. This is mainly because the continuing rising of
government debt A country's gross government debt (also called public debt, or sovereign debt) is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit oc ...
, due to the
Great Recession The Great Recession was a period of marked general decline, i.e. a recession, observed in national economies globally that occurred from late 2007 into 2009. The scale and timing of the recession varied from country to country (see map). At ...
, has been offsetting the deleveraging in the private sectors in many countries.


Historical episodes of deleveraging

The
McKinsey Global Institute McKinsey & Company is a global management consulting firm founded in 1926 by University of Chicago professor James O. McKinsey, that offers professional services to corporations, governments, and other organizations. McKinsey is the oldest and ...
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. According to this definition, there have been 45 such episodes of deleveraging since 1930, including: * The Great Depression in the United States: 1929-43 * United Kingdom: 1947-80 *
Malaysia Malaysia ( ; ) is a country in Southeast Asia. The federation, federal constitutional monarchy consists of States and federal territories of Malaysia, thirteen states and three federal territories, separated by the South China Sea into two r ...
: 1998-2008 *
Mexico Mexico (Spanish: México), officially the United Mexican States, is a country in the southern portion of North America. It is bordered to the north by the United States; to the south and west by the Pacific Ocean; to the southeast by Guatema ...
: 1982-92 *
Argentina Argentina (), officially the Argentine Republic ( es, link=no, República Argentina), is a country in the southern half of South America. Argentina covers an area of , making it the second-largest country in South America after Brazil, th ...
: 2002-2008 Based on this identification of deleveraging and
Carmen Reinhart Carmen M. Reinhart (née Castellanos, born October 7, 1955) is a Cuban-American economist and the Minos A. Zombanakis Professor of the International Financial System at Harvard Kennedy School. Previously, she was the Dennis Weatherstone Senior Fe ...
and
Kenneth Rogoff Kenneth Saul Rogoff (born March 22, 1953) is an American economist and chess Grandmaster. He is the Thomas D. Cabot Professor of Public Policy and professor of economics at Harvard University. Early life Rogoff grew up in Rochester, New York. ...
’s definition for major episodes of
financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
, it is found that almost every major financial crisis during the period of study has been followed by a period of deleveraging. 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 their
debt-to-GDP ratio In economics, the debt-to-GDP ratio is the ratio between a country's government debt (measured in units of currency) and its gross domestic product (GDP) (measured in units of currency per year). While it is a "ratio", it is technically measured i ...
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.


Macro-deleveraging process

According to a
McKinsey Global Institute McKinsey & Company is a global management consulting firm founded in 1926 by University of Chicago professor James O. McKinsey, that offers professional services to corporations, governments, and other organizations. McKinsey is the oldest and ...
report, there are four archetypes of deleveraging processes: #"Belt-tightening": this is the most common path of deleveraging for an economy. In order to increase net savings, an economy reduces spending and goes through a prolonged period of
austerity Austerity is a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. There are three primary types of austerity measures: higher taxes to fund spend ...
. # "High
inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
": high inflation mechanically increases nominal GDP growth, thus reducing the debt to GDP ratio. E.g. Chile in 1984–91. # "Massive default": this usually comes after a severe
currency crisis A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated deb ...
. Stock of debt immediately decreases after massive private and public sector defaults. # "Growing out of debt": if an economy experiences rapid (off-trend)
real GDP Real gross domestic product (real GDP) is a macroeconomic measure of the value of economic output adjusted for price changes (i.e. inflation or deflation). This adjustment transforms the money-value measure, nominal GDP, into an index for quantity ...
growth, then its debt to GDP ratio will decrease naturally. E.g. US in 1938–43.


Macro-economic consequences of deleveraging

Massive deleveraging in corporate and financial sectors can have serious macro-economic consequences, such as triggering Fisherian
debt deflation Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults an ...
and slowing
GDP growth Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of ...
. In the
financial market A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...
, the need to deleverage causes
financial intermediaries A financial intermediary is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, pooled investment funds ...
to shed assets and stop lending, resulting in a
credit crunch A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit cr ...
and tighter borrowing constraint for business, especially the small to medium-sized enterprises. Many times, this process is accompanied by a
flight to quality A flight-to-quality, or flight-to-safety, is a financial market phenomenon occurring when investors sell what they perceive to be higher-risk investments and purchase safer investments, such as gold and other precious metals. This is considered a s ...
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, causing
asset prices In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets (for example, inve ...
to collapse. The pressure of
deflation In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...
increases the real burden of debt and spreads loss further in the economy. In addition to causing deflation pressure, firms and households deleveraging their
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a Partnersh ...
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, which in some cases cause a fall in total savings in the economy, despite the individuals' higher propensity to save. This is known as the ''
paradox of thrift The paradox of thrift (or paradox of saving) is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower ''total'' saving ...
''.


Government regulation and fiscal policy

According to the theory of
leverage cycle Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical le ...
of
John Geanakoplos John Geanakoplos (born March 18, 1955) is an American economist, and the current James Tobin Professor of Economics at Yale University. Background and education John Geanakoplos was born to a Greek-American family of scholars. His father was th ...
and originally by
Hyman Minsky Hyman Philip Minsky (September 23, 1919 – October 24, 1996) was an American economist, a professor of economics at Washington University in St. Louis, and a distinguished scholar at the Levy Economics Institute of Bard College. His research att ...
, in the absence of intervention,
leverage Leverage or leveraged may refer to: *Leverage (mechanics), mechanical advantage achieved by using a lever * ''Leverage'' (album), a 2012 album by Lyriel *Leverage (dance), a type of dance connection *Leverage (finance), using given resources to ...
becomes too high in
boom Boom may refer to: Objects * Boom (containment), a temporary floating barrier used to contain an oil spill * Boom (navigational barrier), an obstacle used to control or block marine navigation * Boom (sailing), a sailboat part * Boom (windsurfi ...
times and too low in
bust Bust commonly refers to: * A woman's breasts * Bust (sculpture), of head and shoulders * An arrest Bust may also refer to: Places * Bust, Bas-Rhin, a city in France *Lashkargah, Afghanistan, known as Bust historically Media * ''Bust'' (magazin ...
times. As a result, asset prices become too high in boom times and too low in bad times, rather than correctly reflecting the
fundamental value In finance, the intrinsic value of an asset usually refers to a value calculated on simplified assumptions. For example, the intrinsic value of an option is based on the current market value of the underlying instrument, but ignores the possib ...
of assets. This recurring leveraging-deleveraging cycle is one of the most important amplifying mechanism contributing to the
credit cycle The credit cycle is the expansion and contraction of access to credit over time. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists Post-Keynesian economics is a school of economic thought with its o ...
s and
business cycles Business cycles are intervals of expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by examini ...
. 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 to
recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
and the bottom of the
leverage cycle Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical le ...
. Therefore, some economists, including
John Geanakoplos John Geanakoplos (born March 18, 1955) is an American economist, and the current James Tobin Professor of Economics at Yale University. Background and education John Geanakoplos was born to a Greek-American family of scholars. His father was th ...
, strongly argue that the
Federal Reserve The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States of America. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a ...
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. Moreover, it is more important to restrict leverage in ebullient times to prevent the crash from happening in the first place. In addition, in the face of massive private sector deleveraging,
monetary policy Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
has limited effect, because the economy is likely to have been pushed up against the zero lower bound, where
real interest rate The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approx ...
is negative but
nominal interest rate In finance and economics, the nominal interest rate or nominal rate of interest is the rate of interest stated on a loan or investment, without any adjustments or fees. Examples of adjustments or fees # An adjustment for inflation(in contrast with ...
cannot fall below zero. Some economists, such as
Paul Krugman Paul Robin Krugman ( ; born February 28, 1953) is an American economist, who is Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for ''The New York Times''. In 2008, Krugman was th ...
, have argued that in this case,
fiscal policy In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables ...
should step in and deficit-financed government spending can, at least in principle, help avoid a sharp rise in
unemployment Unemployment, according to the OECD (Organisation for Economic Co-operation and Development), is people above a specified age (usually 15) not being in paid employment or self-employment but currently available for Work (human activity), w ...
and the pressure of
deflation In economics, deflation is a decrease in the general price level of goods and services. Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). Inflation reduces the value of currency over time, but sudden deflation ...
, therefore facilitating the process of private sector deleveraging and reducing the overall damage to the economy.
Gauti B. Eggertsson and Paul Krugman, ''Debt, Deleveraging, and the Liquidity Trap: A Fisher-Minsky-Koo approach'', preliminary draft, November, 2010.
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 high
government budget deficit The government budget balance, also alternatively referred to as general government balance, public budget balance, or public fiscal balance, is the overall difference between government revenues and spending. A positive balance is called a '' ...
could seriously harm the stability and long-run prospect of the economy.


See also

*
Leverage Leverage or leveraged may refer to: *Leverage (mechanics), mechanical advantage achieved by using a lever * ''Leverage'' (album), a 2012 album by Lyriel *Leverage (dance), a type of dance connection *Leverage (finance), using given resources to ...
*
Financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...
*
Debt deflation Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real value because of deflation, causing people to default on their consumer loans and mortgages. Bank assets fall because of the defaults an ...
*
Credit crunch A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit cr ...
*
Liquidity trap A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rathe ...
*
Leverage cycle Leverage is defined as the ratio of the asset value to the cash needed to purchase it. The leverage cycle can be defined as the procyclical expansion and contraction of leverage over the course of the business cycle. The existence of procyclical le ...
*
Paradox of thrift The paradox of thrift (or paradox of saving) is a paradox of economics. The paradox states that an increase in autonomous saving leads to a decrease in aggregate demand and thus a decrease in gross output which will in turn lower ''total'' saving ...
*
Business cycle Business cycles are intervals of Economic expansion, expansion followed by recession in economic activity. These changes have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are ...


References

{{reflist


External links


Video explaining the deleveraging process
Economic crises Financial ratios Debt Business cycle