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Deleveraging: the least bad option?

In the post-crisis context, several complex discussions on its causes have been dividing economists. Although the global crisis may seem far from being solved, the economic recovery seems to gain evidence in some parts of the world.

The adjustment process is not similar across countries in terms of length, implied structural changes or even sacrifices imposed. However what turns out to be historically surprising is that US recovery is not being as fast as past data would predict.

With respect to such matter, in the last Monthly Bulletin, the European Central Bank pointed out one significant headwind to the recovery of US economy: the American household deleveraging process.

Historically, US households presented very high debt-to-income ratios since the 60’s. The trend of indebtedness was upward sloping until reaching the maximum in 2008 (around 128% of the disposable income). In that year, the consequences of the financial bubble altered credit conditions considerably. Thus the deleveraging process started off, something not observed since the Great Depression.  Behind such adjustment, ECB reports the reduction of net borrowing and the general increase in nominal incomes as the main drivers.


The shrink on net borrowing was mainly due to the correction of the expectations regarding real estate assets (as a consequence of the most pronounced correction in nominal house prices since the Great Depression). Second, households felt discouraged to take new debt due to financial conditions imposed after the 2008 crisis. In addition, at the same time, they were subjected to debt-restructuring measures, especially after the estimates of 40-70% household default rate have been disclosed. These conditions, combined with the increase in nominal incomes, gave rise to an unprecedented fall in household debt.  Particularly, the main burden of this deleveraging process was shifted to financial markets.

What is new, and for many people also a big concern, is that this was the first time that US had to deal with a sharp fall in private debt. Data on past cycles show that the debt to income ratio increases on average 8p.p in the 30 quarters precedent to the recessions. In this last one, however, households boosted their debt in 39p.p. Moreover, US individuals usually start acessing credit when a recession ends, which combined with credit availability and positive expectations about the future, improves the recovery of the financial sector.  This is not happening either: debt-to-income variation does not seem to be getting positive soon.

Thus, a very alarming concern arose: with private savings increasing, is the US falling into a paradox of thrift? This paradox states that when agents start to save more after a recessive shock or as an anticipation of worse coming events, their behavior will worsen the conditions through a fall in the aggregate expenditure. That behavior, once followed by a large pie of the economic agents, amplifies the recession because consumption and investment tend to shrink. This would represent a dangerous threat for the growth of the US economy and consequentially for the global economy, considering the weight of the US economy in the world.

Such concern should be in the mind of US authorities: the monetary transmission mechanism does not seem to be working properly because in fact the stimulus are not having the desired effect.

Indeed, the problem is not so much the fact that families are holding more money, but that these “loanable funds” are not being used by the economy, but are rather stashed under the mattress. This is a problem whether it is done by families or rather by banks. In the end, this will remain an issue as long as there is not enough confidence in the profitability of future investments and while the economy has not deleveraged hard enough. Debt was a problem, but this amount of deleveraging has certainly rough drawbacks. It will slowdown the recovery and indeed there will not be a strong recovery without re-starting the demand for borrowing. The key to solving this is getting to a situation where confidence on the future of the economy is enough so that deleveraging does not need to be that hard and borrowing can slowly recover again.

Thus, on the one hand, was not debt one of the main factors that got US economy into the problems? Yes, it was. But at the same time, restarting demand for borrowing seems to be as the key to re-starting economic growth. So in the end debt remains a double-edge sword that requires to be handled carefully.


–       America’s Deleveraging: Still a long way to go, The Economist, 7th Nov 2012

–        How much progress has been achieved in household deleveraging in the United States?, box 1, Monthly Bulletin November 2013, European Central Bank, November 2013

Diogo Matos Mendes #86

José Miguel Cerdeira #628

Macroeconomic Analysis


Author: studentnovasbe

Master student in Nova Sbe

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