An In-Depth Look at DeleveragingsRay Dalio
February 2012
The purpose of this paper is to show the compositions of past deleveragings and, through this process, to convey in-depth, how the deleveraging process works.
The deleveraging process reduces debt/income ratios. When debt burdens become too large, deleveragings must happen. These deleveragings can be well managed or badly managed. Some have been very ugly (causing great economic pain, social upheaval and sometimes wars, while failing to bring down the debt/income ratio), while others have been quite beautiful (causing orderly adjustments to healthy production-consumption balances in debt/income ratios). In this study, we are going to review the mechanics of deleveragings by showing how a number of past deleveragings transpired in order to convey that some are ugly and some are beautiful. What you will see is that beautiful deleveragings are well balanced and ugly ones are badly imbalanced. The differences between how deleveragings are resolved depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots and 4) debt monetization. What we are saying is that beautiful ones balance these well and ugly ones don’t and what we will show below is how.
Before we examine these, we will review the typical deleveraging process.
The Typical Deleveraging Process
Typically, deleveragings are badly managed because they come along about once in every lifetime and policy makers haven't studied them. As a result, they usually set policies like blind men trying to cook on a hot stove, through a painful trial and error process in which the pain of their mistakes drives them away from the bad moves toward the right moves. Since everyone eventually gets through the deleveraging process, the only question is how much pain they endure in the process. Because there have been many deleveragings throughout history to learn from, and because the economic machine is a relatively simple thing, a lot of pain can be avoided if they understand how this process works and how it has played out in past times. That is the purpose of this study.
As previously explained, the differences between deleveragings depend on the amounts and paces of 1) debt reduction, 2) austerity, 3) transferring wealth from the haves to the have-nots, and 4) debt monetization.
Each one of these four paths reduces debt/income ratios, but they have different effects on inflation and growth. Debt reduction (i.e., defaults and restructurings) and austerity are both deflationary and depressing while debt monetization is inflationary and stimulative. Ugly deleveragings get these out of balance while beautiful ones properly balance them. In other words, the key is in getting the mix right.
Typically, in response to a debt crisis the going to these four steps takes place in the following order:
1) At first, problems servicing debt and the associated fall off in debt growth cause an
economic contraction in which the debt/income ratios rise at the same time as economic activity and financial asset prices fall. We will call this phase an “ugly deflationary deleveraging”. Debt reduction (i.e., defaults and restructurings) and austerity without material debt monetization characterize this phase. During this period, the fall in private sector credit growth and the tightness of liquidity lead to declines in demand for goods, services and financial assets. The financial bubble bursts when there is not enough money to service the debt and debt defaults and restructurings hit people, especially leveraged lenders (banks), like an avalanche that causes fears. These justified fears feed on themselves and lead to a liquidity crisis.
As a result, policy makers find themselves in a mad scramble to contain the defaults before they
spin out of control. This path to reducing debt burdens (i.e., debt defaults and restructurings)
must be limited because it would otherwise lead to a self-reinforcing downward spiral in which
defaults and restructurings can be so damaging to confidence that, if let go, they might prevent
faith and recoveries from germinating for years. Defaults and restructurings cannot be too large or too fast because one man's debts are another man's assets, so the wealth effect of cutting the
value of these assets aggressively can be devastating on the demands for goods, services and
investment assets. Since in order to reduce debt service payments to sustainable levels the
amount of write-down must equal what is required so the debtor will be able to pay (e.g., let's say it’s 30% less), a write-down will reduce the creditor's asset value by that amount (e.g. 30%). ...MUCH MORE (31 page PDF)
HT: The Daily Capitalist
