Age of Deleveraging

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= As we enter this Age of Deleveraging, the worst thing we can do is apply policies that appeared to work during the preceding Age of Leverage—but were in fact predicated on ever-rising private sector indebtedness. [1]


Steve Keen:

"The “Global Financial Crisis”, which began in late 2007, marked a turning point in the nature of market economies. Their performance from at least the mid-1960s had been under-written by a faster growth of private debt than of GDP: this was the “Age of Leverage”. In late 2007, the growth rate of private debt fell, and since then we have been in the Age of Deleveraging.

The statistics of the Ages are stark enough: private debt rose sixfold compared to GDP in America from 1945, and sixfold in Australia from 1965. Pre-1988 figures aren’t available for UK debt, but clearly it has exploded since 1988. All three ratios peaked after 2007, and have since been falling. The fall in the US ratio is clearly unprecedented in the post-WWII period: only the Great Depression compares.


The change in debt therefore does have serious macroeconomic consequences, since an increase in debt adds to aggregate demand—and it is the primary means by which both investment (Fama and French 2002) and speculation (Minsky 1982, pp. 28-30) are funded.

In a credit-based economy, aggregate demand is therefore the sum of income plus the change in debt, with the change in debt spending new money into existence in the economy. This is then spent not only goods and services, but on financial assets as well—shares and property. Changes in the level of debt therefore have direct and potentially enormous impacts on the macroeconomy and asset markets, as the GFC—which was predicted only by a handful of credit-aware economists (Bezemer 2009)—made abundantly clear.

If the change in debt is roughly equivalent to the growth in income—as applied in Australia from 1945 to 1965, when the private debt to GDP ratio fluctuated around 25 per cent (see Figure 1)—then nothing is amiss: the increase in debt mainly finances investment, investment causes incomes to grow, and the economy moves forward in a virtuous feedback cycle. But when debt rises faster than income, and finances not just investment but also speculation on asset prices, the virtuous cycle gives way to a vicious positive feedback process: asset prices rise when debt rises faster than income, and this encourages more borrowing still.

The result is a superficial economic boom driven by a debt-financed bubble in asset prices. To sustain a rise in asset prices relative to consumer prices, debt has to grow more rapidly than income—in other words, if asset prices are to rise faster than consumer prices, then rather than merely rising, debt has to accelerate. This in turn guarantees that the asset price bubble will burst at some point, because debt can’t accelerate forever. When debt growth slows, a boom can turn into a slump even if the rate of growth of GDP remains constant.

This process is easily illustrated in a numerical example. Consider an economy with a GDP of $1 trillion that is growing at 10% per annum, with real growth of 5% and inflation of 5%, and in which private debt is $1.25 trillion and growing at 20% p.a. Total spending on both goods & services and financial assets is therefore $1.25 trillion: $1 trillion is financed by income, and $250 billion is financed by the 20% increase in debt.

In the following year, if the growth of debt simply slows down to the same rate at which nominal GDP is growing (without affecting the rate of economic growth), then the growth in debt will be $150 billion (10% of the $1.5 trillion level reached at the end of the previous year). Total spending will therefore be exactly the same as the year before: $1.25 trillion, consisting of $1.1 trillion in GDP plus a $150 billion growth in debt. However, since inflation is running at 5%, this amounts to a 5% fall in the real level of economic activity—which would be spread across both commodity and asset markets.

If instead the growth of debt stopped, then total spending the next year will be $1.1 trillion, a 15% fall from the level of the previous year in nominal terms, and 20% in real terms. This would cause a massive slump in demand for goods & services, assets, or both, even without a slowdown in the rate of growth of GDP.


his is why the shift from the Age of Leverage to the Age of Deleveraging was so dramatic, and yet so unforeseen by conventional economists: it was caused by a huge reduction in aggregate demand from a factor they ignore. This debt-induced reduction in aggregate demand will persist as long as private debt levels are falling—as they still are in the USA, though at a much reduced rate from the peak rate of fall in early 2010.

Until private debt levels are substantially reduced, the economy will always tend towards what Richard Koo called a “balance sheet recession” (Koo 2009), where the desire of the private sector to reduce its leverage will suppress aggregate demand, causing both recessions and falling asset prices. The Western OECD is thus “turning Japanese”—replicating the crisis that led to Japan’s “Lost Decade”, which is now two decades old.

Koo argues that whether the world experiences the relatively minor decline in Japanese economic performance or achieves something much worse depends in part on whether the world mimics Japan’s policy response or not. But whereas conventional wisdom argues that Japan has failed by running huge government deficits, Koo argues that without these deficits, Japanese GDP would have fallen far more.

His reasoning is that, just as private sector borrowing spends additional money into existence, so too does a government deficit. But if the private sector is deleveraging—as it has done in Japan since 1991 and is now doing in the USA—then the change in private debt is actually subtracting from demand. Japan’s public sector deficits therefore attenuated the decline in aggregate demand: - Although this fiscal action increased government debt by … 92 percent of GDP during the 1990–2005 period, the amount of GDP preserved by fiscal action compared with a depression scenario was far greater. For example, if we assume, rather optimistically, that without government action Japanese GDP would have returned to the pre-bubble level of 1985, the difference between this hypothetical GDP and actual GDP would be over 2,000 trillion yen for the 15-year period. In other words, Japan spent 460 trillion yen to buy 2,000 trillion yen of GDP, making it a tremendous bargain. And because the private sector was deleveraging, the government’s fiscal actions did not lead to crowding out, inflation, or skyrocketing interest rates. (Koo 2011, p. 23)

On the other hand, Koo cautions that if the government attempts to run a surplus while the private sector is deleveraging, there will be two factors reducing economic activity at the same time. He therefore argues that deficits are sensible when the private sector is deleveraging, while attempting to run surpluses will make a bad situation worse:

- Although shunning fiscal profligacy is the right approach when the private sector is healthy and is maximizing profits, nothing is worse than fiscal consolidation when a sick private sector is minimizing debt. (Koo 2011, p. 27)

However, fiscal consolidation is the policy prescription that is being applied in the Euro zone and the UK, and supported by politicians in both Australia and the USA. The likely outcome of public austerity is thus a further decrease in the growth rate of countries practicing it. Given that most of the Western OECD is already under severe economic stress, the pain that austerity inflicts upon already stressed societies is likely to mean drastic political change.

The most obvious location for political turmoil is Europe, where the Maastricht Treaty’s rules force countries to attempt to restrain fiscal deficits to 3% of GDP. This was always a bad idea, predicated on the belief that severe economic crises could not occur. Though the treaty was applauded by neoclassical economists, I was far from the only non-neoclassical economist to observe that this treaty could lead to the breakup of Europe when a recession hit, since “Europe’s governments may be compelled to impose austerity upon economies which will be in desperate need of a stimulus” (Keen 2001, pp. 212–13; see also Keen 2011, pp. 2-3).

Though continental Europe is the most obvious location for economically inspired political instability in 2012, another dark horse may also be the UK. As Figure 1 shows, its private debt level is staggeringly high—one and a half times the peak level of the USA’s—and yet it did not suffer as severe a downturn as the USA when the crisis began because, as Figure 2 indicates, it did not fall as deeply into deleveraging. The maximum decline in aggregate demand caused by falling private debt in the UK was only 6 percent of GDP, versus 20 percent in the USA.

However the rate of deleveraging in the UK has again hit this level, while the USA has recovered from the worst of the initial downturn and is deleveraging at a rate of only 3% of GDP. Governments in both the USA and the UK are favouring austerity policies, but the UK is already imposing them—with thus far negative results—and is far more likely to be able to maintain them than the politically hamstrung USA. This means that private sector deleveraging and public sector austerity may coincide in the UK in 2012, which from a “balance sheet recession” perspective indicates that the UK could fall into recession from an already depressed level of economic activity. This is especially likely if the rate of private sector deleveraging accelerates." (