Deleveraging Not Over Yet

The debt deleveraging process is still in its infancy, I don’t care what the happy talkers say on TV. Last week, the McKinsey Global Institute issued a report looking at where the world’s rich economies lie along the spectrum of debt reduction. America’s ratio of total debt to GDP (which includes debt owed by households, government, non-financial businesses, and the financial industry) comes in at just under 300%. As awful as that sounds, it’s actually lower than in many other countries. Britain and Spain, for instance, are looking at 465% and 365% respectively.

For the US, the report assigned high odds of further deleveraging on the way in the household and commercial real estate sector, two areas we flagged in The Kelly Letter last year as walking down a long road to anything remotely akin to balance.

To ascertain the economic impact of deleveraging to come, the report defines sustained deleveraging as at least three consecutive years in which total debt to GDP declines by at least 10%. It found 32 historical examples of such. Some were resolved by debt defaulting away, others by it inflating away, but around half were resolved by an extended period of austerity during which credit grew less quickly than production. It happens to view the austerity periods as the ones most appropriate to understanding what lies ahead for us today. About those episodes in the report, last week’s Economist wrote:

Typically deleveraging began about two years after the beginning of the financial crisis and lasted for six to seven years. In almost every case output shrank for the first two or three years of the process.

Worse, there are several reasons why today’s mess could be more protracted than previous episodes. First, the scale of indebtedness is higher. The highest debt ratio in the report’s group of belt-tighteners was 286%, in Britain after the second world war. Today more than half the rich countries in the McKinsey sample have debt totalling more than 300% of GDP. Second, the number of countries afflicted simultaneously means that rapid expansions of exports, which have supported output in the past, are harder to achieve. Third, big increases in public debt, while cushioning demand in the short term, increase the overall debt reduction that will eventually be needed. Once private deleveraging is done, the public sector will need to cut back.

In theory that sounds simple. In practice it will be fiendishly hard to get the balance right. Investors may worry about the sustainability of public debt long before private-debt reduction is over, forcing a lot of belts to be tightened at once. The most painful bits of deleveraging could well lie ahead.

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