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A painful belt-tightening exercise is underway in many of the biggest developed economies. Deleveraging, at the macroeconomic level, means reducing debt as a proportion of GDP. Household debt levels rose dramatically in the decade leading up to the 2008 financial crisis. As the chart, they have started to decline, but remain well above their long-term averages.
Household debt (% of GDP)
The benign economic backdrop of the ‘Great Moderation’ and expansionary monetary policy contributed to the rapid growth in indebtedness. Together, they increased global economic confidence and facilitated the availability of credit. This encouraged rising asset prices, which in turn encouraged further borrowing and started an unsustainable credit and real estate bubble that burst in the US in 2006-07. As asset prices fell, highly leveraged institutions suffered significant deteriorations in their balance sheets. Banks cut back lending, while nervous businesses and consumers were reluctant to borrow. To prevent this private sector deleveraging from leading to financial meltdown, unprecedented monetary easing and fiscal expansion were enacted, increasing public debt and creating pressure for public sector deleveraging.
The challenge for investors is to assess the implications of this deleveraging. As debt ratios remain considerably higher than historical levels, the private sector will be incentivized to reduce debt toward long-term norms. However, private sector debt consolidation will hamper long-term investment and dampen economic recovery. This implies that we could enter a prolonged period of more volatile growth, with higher risks of recession and debt deflation. To prevent such a situation occurring, interest rates may well remain at unprecedentedly low levels in the US, the eurozone and the UK. Once private sector debt reaches sustainable levels and signs of sustainable economic recovery emerge, governments can then consolidate their finances. Both private sector and public sector deleveraging are painful, but maximum pain can be avoided if they do not happen at the same time.